INTERNATIONAL  TRADE 
AND   EXCHANGE 


THE  MACMILLAN  COMPANY 

NEW  YORK   •    BOSTON  •   CHICAGO  •   DALLAS 
ATLANTA  •    SAN   FRANCISCO 

MACMILLAN  &  CO.,  LIMITED 

LONDON  _•    BOMBAY  •    CALCUTTA 
MELBOURNE 

THE  MACMILLAN  CO.  OF  CANADA,  LTD. 

TORONTO 


INTERNATIONAL  TRADE 
AND  EXCHANGE 


A  STUDY  OF  THE  MECHANISM  AND 
ADVANTAGES  OF  COMMERCE 


BY 


HARRY   GUNNISON    BROWN 

INSTRUCTOR   IN   POLITICAL   ECONOMY 
IN   YALE   UNIVERSITY 


THE   MACMILLAN   COMPANY 
1914 

All  rights  reserved 


COPYRIGHT,  1914, 
BY  THE  MACMILLAN  COMPANY. 

Set  up  and  clectrotyped.    Published  November,  1914. 


NottoootJ 

J.  8.  Gushing  Co.  —  Berwick  &  Smith  Co. 
Norwood,  Mass.,  U.S.A. 


PREFACE 

IN  this  book  I  have  aimed  to  cover  the  theory  of 
international  and  in^ranational  trade,  with  due  consid- 
eratiorTof  the  exchange  mechanism  of  such  trade,  and 
with  some  reference  to  the  effects  of  government  inter- 
ferences with  trade.  The  larger  emphasis,  as  the  title 
of  the  book  suggests,  is  on  international  trade ;  but  the 
similarity  of  principle  in  intranational  trade  is  not  over- 
looked. 

I  originally  planned  a  somewhat  longer  work,  on  the 
Principles  of  Commerce,  to  include  also,  as  Part 
The  Transportation  Expenses  of  Commerce.  The  carry-! 
ing  out  of  this  plan  has  not  been  given  up ;  but  it  h; 
seemed  advisable  not  to  delay  the  publication  of  Parts 
and  II,  which  together  make  a  unified  whole,  until 
Part  III  is  likewise  ready  for  printing.  My  hope  is 
that  the  larger  book  may  be  completed  and  published 
in  the  not  distant  future.  In  the  meanwhile,  the  present 
book,  containing,  perhaps,  a  more  conventional  combi- 
nation of  topics,  may  possibly  fill  a  place  which  the 
more  extended  work  could  not  fill. 

Part  I  deals  chiefly  with  the  subject  of  Foreign  Ex- 
change,  though  it  also  contains  two  introductory  chapters 
on  Laws  of  Money  and  The  Nature  of  Banking,  which, 
in  my  judgment,  make  possible  a  clearer  understanding 
of  the  economic  theory  of  foreign  exchange  operations. 
In  this  Part,  I  have  endeavored  to  analyze,  more  fully 
than  is  usually  done,  the  interrelations  of  different  per- 
sons, buyers  and  sellers,  et  al,  in  the  credit  mechanism 

Y 

3438 


vi  PREFACE 

of  exchange,  —  to  show  who  are  the  ultimate  creditors 
when  bank  checks  and  bank  notes  are  used  in  trade 
and  when  bills  of  exchange  (especially  "  long  bills  ")  are 
used.  Thus,  after  the  explanation  of  the  nature  of 
banking,  the  reader  is  led,  in  Chapter  III,  The  Nature 
and  Method  of  Foreign  Exchange,  to  an  appreciation  of 
the  international  nature  of  the  credit  relations  growing 
out  of  trade.  The  flow  of  money  from  country  to  coun- 
try having  been  explained  briefly  in  Chapter  I,  the 
relation  of  this  flow  to  the  rate  of  exchange  and  to 
fluctuations  in  the  rate  of  exchange  is  set  forth  at 
length  in  Chapter  V.  In  the  last  chapter  of  Part  I, 
emphasis  is  placed  on  the  fact,  ordinarily  passed  with- 
out mention,  that  whatever  may  be  the  relation  or  non- 
relation  of  the  currency  of  a  country  to  the  currencies 
of  other  countries,  its  trade  with  them  cannot  all  be 
either  an  export  or  an  import  trade  for  any  great  while, 
without  introducing  a  tendency  to  a  reverse  flow  or  to 
equilibrium. 

Part  II  begins  with  a  discussion  of  the  gains  of  trade, 
whether  the  trade  is  between  countries  or  wholly  within 
a  single  country.  Attention  is  then  turned  to  the  con- 
ditions determining  the  share  which  each  of  two  or  more 
countries  gets  from  trade  between  them.  The  remain- 
der of  Part  II  is  devoted  to  a  consideration  of  revenue 
tariffs,  protective  tariffs,  bounties,  navigation  acts,  gov- 
ernment construction  of  canals  for  the  free  use  of  com- 
mercial interests,  land  grants  in  encouragement  of 
railroad  building,  etc.  Proposals  for  such  indirect  en- 
couragement to  commerce  as  is  afforded  by  the  last  two 
policies,  are  perhaps  no  less  frequent  and  insistent  than 
are  proposals  for  its  direct  encouragement  by  means  of 
bounties  or  for  its  discouragement  by  means  of  pro- 
tective tariffs.  Analysis  of  the  effects  to  be  expected 


PREFACE 


Vll 


from  such  policies  may  be  as  important,  therefore,  as 
analysis  of  the  effects  of  a  protective  tariff  or  bounty 
system. 

The  preliminary  analysis  of  the  mechanism  of  trade, 
given  in  Part  I,  makes  it  easy  to  discuss  international 
trade,  protective  tariffs,  etc.,  in  terms  of  money  prices 
as  well  as  more  generally.  To  many  students,  accus- 
tomed to  think  in  terms  of  money  prices,  even  in  terms 
of  mercantilism,  such  a  method  of  presentation  may  be 
the  only  convincing  one.  In  the  case  of  protective 
tariffs,  not  only  is  it  shown  in  a  general  way  that  pro- 
tection tends  to  divert  a  country's  industry  out  of  its 
natural  channels,  but,  in  addition,  the  effects  of  protec- 
tion on  national  wealth  are  traced  by  showing  that 
money  prices  are  raised  by  this  policy  more  than  are 
average  money  incomes.  It  is  pointed  out  that  the 
tariff  has  two  effects  on  prices,  primary  and  secondary. 
In  the  first  place,  the  prices  of  protected  goods  are 
directly  raised  by  the  tariff,  because  of  the  exclusion  of 
cheaper  foreign  goods.  This  rise  applies  only  to  pro- 
tected goods,  not  to  money  incomes.  Next,  protection, 
since  it  decreases  imports,  increases  the  quantity  of 
money  in  the  protectionist  country;  and  this  increase 
of  money  brings  a  secondary  rise  of  prices  affecting 
protected  goods,  unprotected  goods  and  money  incomes. 
The  rise  of  money  incomes  compensates  for  the  sec- 
ondary rise  of  general  prices  but  does  not  compensate  for 
the  original  rise  of  prices  of  the  protected  goods.  There- 
fore, average  prosperity  is  decreased.  In  the  same  way, 
the  effects  of  protection  on  wages  and  on  land  rent  are 
set  forth  in  general  terms  and  in  terms  of  money  prices. 

Throughout,  I  have  endeavored  to  keep  in  view  the 
requirement  of  clearness,  although  not  avoiding  discus- 
sion of  difficult  points.  To  this  end,  concreteness  has 


viii  PREFACE 

been  given  to  the  arguments  presented,  by  the  use  of 
both  hypothetical  and  real  examples;  and  the  main 
conclusions  of  each  chapter  have  been  summarized  in 
the  last  section  of  the  chapter.  The  more  analytical 
and  controversial  discussions  have  been,  in  large  part, 
consigned  to  footnotes.  I  have  sought  thus  to  write 
a  book  which  can  serve  as  a  text,  but  which  may  be 
also  not  without  interest  to  professional  economists. 

Acknowledgment  should  be  here  made  of  various 
courtesies  extended,  and  of  the  aid  rendered  by  a  num- 
ber of  friends  who  have  done  much  toward  removing 
errors  of  statement  and  expression  and  in  suggesting 
critical  and  illustrative  additions.  To  the  Quarterly 
Journal  of  Economics  I  am  under  obligation  for  permis- 
sion to  include,  in  Chapter  II  of  Part  I,  substantially 
without  change,  an  article  on  Commercial  Banking  and 
the  Rate  of  Interest,  originally  published  in  August,  1910. 
To  Brown  Brothers  of  New  York  I  am  indebted  for 
information  on  a  number  of  special  points  regarding 
foreign  exchange.  To  one  of  my  students,  Mr.  Law- 
rence M.  Marks,  Yale  1914,  I  am  indebted  for  the 
calculation  of  seasonal  sterling  exchange  rates,  presented 
in  a  footnote  of  Part  I,  Chapter  IV,  Section  2.  Mr. 
Franklin  Escher,  of  New  York  City,  editor  of  Invest- 
ment, has  given  me  the  benefit  of  a  careful  criticism  of 
the  manuscript  of  Part  I,  particularly  regarding  the 
matter  of  conformity  of  statement  to  business  practice. 
To  Professor  F.  R.  Fairchild  of  Yale  College  I  am 
indebted  for  a  searching  criticism  of  Part  I  from  the 
standpoint  both  of  theory  and  of  form.  Professor  G  S. 
Callender,  of  the  Sheffield  Scientific  School,  Yale  Uni- 
versity, to  whom  I  submitted  the  manuscript  of  Part  II, 
has  made  a  number  of  valuable  criticisms  and  sugges- 
tions. I  am  under  obligation,  also,  for  critical  reading 


PREFACE 


IX 


of  a  number  of  the  more  important  chapters  of  the 
book,  to  Professors  Irving  Fisher,  Clive  Day,  and  H.  C. 
Emery  of  Yale  College  and  to  Professor  John  Bauer  of 
Cornell  University.  Finally,  I  would  acknowledge  here 
the  obligation  I  am  under  to  my  wife,  who  has  given  me 
valuable  assistance  in  the  gathering  of  data,  in  reading 
and  criticising  the  manuscript  in  its  various  stages  of 
completion,  and  in  correcting  the  proof. 

HARRY   GUNNISON   BROWN. 
NEW  HAVEN,  CONN. 
October,  1914. 


CONTENTS   BY   SECTIONS 

PART  I  — THE  EXCHANGE  MECHANISM  OF 
COMMERCE 

FACE 

CHAPTER  I  —  LAWS  OF  MONEY 1-25 

§  i.  Quantitative  Statement  of  the  Relation  between 
Money  and  Prices 

§  2.  Causa]  Explanation  of  the  Price  of  a  Given  Kind  of 
Goods 

§  3.  Causal  Explanation  of  the  General  Level  of  Prices 

§  4.  Causal  Explanation  of  the  Value  or  Purchasing  Power 
of  Money,  the  Reciprocal  of  the  Level  of  Prices  of 
Goods 

§  5.  The  Theory  of  Bimetallism 

§  6.  The  Value  of  Subsidiary  Money 

§  7.  The  Value  of  Money  as  Related  to  the  Value  of  a  Stand- 
ard Money  Metal 

§  8.  The  Level  of  Prices  and  the  Value  of  Money  in  One 
Country  or  Locality  as  Related  to  the  Level  of 
Prices  and  the  Value  of  Money  in  Another 

§  9.  Summary 

CHAPTER  n  —  THE  NATURE  OF  BANK  CREDIT   .        .        26-50 
§  i.  How  and  When  Credit  Takes  the  Place  of  Money 
§  2.  How  Commercial  Banking  is  Carried  On 
§  3.  Analysis  of  Relations  Involved  hi  Commercial  Bank- 
ing 

§  4.  Why  Commercial  Banking  Commends  Itself  to  Busi- 
ness Men,  both  as  Lenders  and  Borrowers,  so  that 
Commercial  Bank   Credit  becomes  a    Substitute 
for  Money 
§  5.  Application  of  Principles  Arrived  at,  to  Bank  Notes 


xii  CONTENTS  BY  SECTIONS 


§  6.  Quantitative  Statement  of  the  Relation  of  Money, 

together  with  Bank  Credit,  to  Prices 
§  7.  Fluctuations  of  Bank  Credit 
§  8.  Summary 

CHAPTER  III  —  THE  NATURE  AND  METHOD  OF  FOREIGN 

EXCHANGE 51-76 

§  i.  The  Function  of  Bills  of  Exchange 

§  2.  The  Nature  of  Bills  of  Exchange 

§  3.  How  Bills  of  Exchange  Might  be  Used  to  Settle  Obli- 
gations, Assuming  no  Banks 

§  4.  Settlement  of  Obligations  by  Drafts  (Bills  of  Ex- 
change), through  Intermediation  of  Banks,  Assum- 
ing Creditors  to  Draw  Drafts  on  Debtors 

§  5.  Settlement  of  Obligations  by  Bank  Drafts,  when 
Debtors  Remit  to  Creditors 

§  6.  How  Exchange  Banks  Make  Profits 

§  7.  Various  Types  of  Drafts 

§  8.  The  Sale  of  Demand  Drafts  against  Remittances  of 
Long  Bills 

§  9.  Summary 

CHAPTER  IV  —  THE  RATE  OF  EXCHANGE    .        .        .      77-102 

§  i.  The  Meaning  of  Par  of  Exchange 

§  2.  The  Supply  of  and  the  Demand  for  Bills  of  Ex- 
change 

§  3.  The  Effect  on  the  Exchange  Market  of  any  Country 
^<>  of  Disturbed  Political  or  Industrial  Conditions  in 
That  Country,  and  in  Other  Countries 

§  4.  Analysis  of  the  Relations  Involved  in,  and  Explana- 
tion of  the  Results  of,  Short  Time  Loans  Made 
Ostensibly  by  Foreign  Banks,  through  the  Inter- 
mediation of  the  Exchange  Market 

§  5.  Finance  Bills,  What  they  Are,  Whose  Accumulations 
Make  them  Possible,  and  What  are  their  Results 

§  6.  How  a  Bank  in  One  Country  and  a  Bank  in  Another 
May,  through  the  Aid  of  the  Exchange  Market, 
Invest  in  One  of  the  Countries  for  Joint  Account, 
without  Either  Bank  Using  its  Own  Funds 


CONTENTS  BY  SECTIONS  xiii 

TACK 

§  7.  Analysis  of  the  Relations  Involved  in  a  Letter  of 

Credit 

§  8.  Place  Speculation  or  Arbitraging  in  Exchange 
§  9.  Time  Speculation  in  Exchange 
§  10.  Summary 

CHAPTER  V  —  THE  RATE  OF  EXCHANGE  AND  THE  FLOW  OF 

SPECIE  103-125 

§  i.  The  Upper  Limit  to  Fluctuation  of  the  Rate  of  Ex- 
.  change,  Determined  by  the  Cost  of  Exporting 
Specie 

§  2.  Some  Details  Connected  with  the  Exportation  of 
Specie 

§  3.  The  Lower  Limit  to  Fluctuation  of  the  Rate  of  Ex- 
change, Determined  by  the  Cost  of  Importing 
Specie 

§  4.  Circumstances  which  May  Cause  the  Rate  of  Ex- 
change to  Fall  Below  What  is  Usually  its  Lower 
Limit 

§  5.  The  Cost  of  Money  Shipment  in  Domestic  Exchange 

§  6.  The  Long  Run  Effect  of  a  Balance  of  Payments  from 
One  Country  to  Another,  for  Commodities  or 
Services 

£7)  The  Long  Run  Effect  of  International  Investments 
upon  the  Rate  of  Exchange  and  the  Flow  of 
Money 

§  8.  The  Long  Run  Effect  of  Various  Other  Payments  from 
One  Country  to  Another 

§  9.  Summary 

CHAPTER  VI  —  FURTHER  CONSIDERATIONS  REGARDING  THE 

RATE  OF  EXCHANGE 126-153 

§  i.  The  Price  of  Long  Drafts  Determined  in  Part  by  the 

Rate  of  Interest  or  Discount 
§  2.  How  Long  Drafts  on  Foreign  Countries  are  Held  as 

Investments  by  American  Banks 
§  3.  Influence  on  the  Price  of  Long  Drafts,  of  Interest 

Rate  in  Drawing  Country  and  of  Interest  Rate  in 

Country  Drawn  Upon 


xiv  CONTENTS  BY   SECTIONS 


§  4.  How  and  Why  the  Bank  Discount  Rate  Affects  the 
Price  of  Demand  Drafts  and  the  Flow  of  Specie 

§  5.  Effect  of  a  Panic  in  One  Country  on  Conditions  in 
Other  Countries 

§  6.  Exchange  between  Two  Countries  when  One  has  a 
Gold  and  the  Other  a  Silver  Standard 

§  7.  Exchange  between  Two  Countries  when  One  has  a 
Gold  and  the  Other  an  Inconvertible  Paper  Stand- 
ard 

§  8.  Exchange  between  Two  Countries  when  Both  have 
Inconvertible  Paper  Standards 

§  9.  Exchange  between  Two  Countries,  Assuming  Effec- 
tive Prohibition  of  Specie  Shipment 

§  10.  The  Effect  on  the  Rate  of  Exchange  of  High  Im- 
port and  Export  Duties 

§11.  Summary 


PART  II  — THE   ECONOMIC   ADVANTAGES  OF 
COMMERCE 

CHAPTER  I  —  PRICES,  INTERCOMMUNITY  TRADE,  AND  THE 

GAINS  OF  TRADE 3-18 

§  i.  The  Relation  of  Prices  in  One  Country  to  Prices  in 
Another 

§  2.  What  Prices  Tend  to  be  Lower  in  a  Given  Country, 
than  Prices  of  the  Same  Kinds  of  Goods  in  Another 
Country 

(§3)  Trade  between  Two  Communities  when  Each  has  an 
Absolute  Advantage  over  the  Other,  in  One  or 
More  Lines  of  Production 

§  4.  Trade  between  Two  Communities  or  Countries 
when  One  is  More  Productive  than  the  Other 
in  Several  or  in  All  Lines,  but  has  a  Greater  Advan- 
tage in  One  Line  or  in  a  Few  Lines,  than  in  the 
Rest 

§  5.  Summary 


CONTENTS   BY   SECTIONS  xv 

PAGE 

CHAPTER  II  —  THE  RATE  OF  INTERCHANGE  OF  GOODS  BE- 
TWEEN COMMUNITIES 19-38 

§  i.  The  Limits  to  the  Rate  at  which  the  Goods  of  One 
Country  Exchange  for  Those  of  Another 

§  2.  Conditions  of  Supply  and  Demand  Determining  the 
Exact  Rate  of  Interchange  between  these  Limits 

§  3.  Effect  on  this  Rate,  when  One  of  the  Countries 
Offers  a  Variety  of  Goods  in  Trade,  and  also  when 
it  Receives  Periodic  Payments  of  Obligations  from 
the  Other 

§  4.  Influence  on  Trade  and  the  Rate  of  Trade  of  Produc- 
tion in  any  Country  under  Conditions  of  Different 
Cost 

§  5.  Extension  of  Hypothesis  so  as  to  Include  Trade  In- 
volving More  than  Two  Countries 

§  6.  Cost  of  Transportation  as  Related  to  Trade 

§  7.  Summary 

CHAPTER  III  —  THE  INCIDENCE  OF  TARIFFS  FOR  REVENUE  39-56 
§  i.  Revenue  and  Protective  Tariffs  Distinguished 
§  2.  When  the  Burden  of  an  Import  Duty  Levied  for  Rev- 
enue is  Borne  by  the  Levying  Country 
§  3.  When  the  Burden  of  an  Import  Duty  Levied  for 
Revenue    is    Shifted    by   the   Levying    Country 
to  Another  or  to  Other  Countries 
§  4.  The  Ultimate  Incidence   of   a  Revenue   Duty  on 

Exports 
§  5.  Summary 

CHAPTER  IV  — THE  EFFECT  OF  A  PROTECTIVE  TARIFF  ON 

NATIONA/.  WEALTH  .....  57-85 

§  i.  The  EffeU  of  a  Protective  Tariff  on  a  Country's 
Export  Trade 

§  2.  How  a  Protective  Tariff  Sets  up  Unprofitable  Indus- 
tries at  the  General  Expense 

§  3.  The  Effect  of  Potection  on  the  Money  Prices  of  Pro- 
tected Goods  and  on  the  Money  Prices  of  Unpro- 
tected Goods 


rvi  CONTENTS   BY   SECTIONS 


§  4.  Protection  to  Industries  in  which  Large  Scale  Pro- 
duction is  Advantageous 

§  5.  Protection  to  Industries  of  Increasing  Cost 

§  6.  Effect  of  a  Country's  Protective  Tariff  System  on 
the  Cost  to  it  of  Unprotected  Goods  Got  from 
Other  Countries 

§  7.  A  Tariff  "Equal  to  the  Difference  in  Cost  of  Pro- 
duction at  Home  and  Abroad,  together  with  a 
Reasonable  Profit" 

§  8.  Relative  Advantages  in  the  World's  Commerce  of 
Countries  having  High  and  Countries  having 
Low  or  No  Tariffs 

§  9.  Summary 

CHAPTER  V.  —  THE  EFFECTS  OF  PROTECTION  ON  THE  DIS- 
TRIBUTION OF  NATIONAL  WEALTH  AMONG  ECONOMIC 
CLASSES  AND  AMONG  TERRITORIAL  SECTIONS  .  86-115 

§  i.  Effect  of  Protection  on  the  Rate  of  Interest  and 
Therefore  on  Wages 

§  2.  Brief  Statement  of  Laws  of  Wages  and  Land  Rent 

§  3.  The  Effect  of  Protection  on  Wages  when  Protected 
and  Unprotected  Goods  are  Produced  in  the  Pro- 
tectionist Country,  under  Conditions  of  Substan- 
tially Constant  Cost 

§  4.  The  Effect  of  Protection  on  Wages  and  Rent  when 
the  Protected  Goods  are  Produced  under  Condi- 
tions of  Sharply  Increasing  Cost 

§  5.  The  Effect  of  Protection  on  Wages  and  Rent  when 
Unprotected  Goods  are  Produced  under  Conditions 
of  Sharply  Increasing  Cost 

§  6.  How  Protection  May  Benefit  One  Section  of  a  Coun- 
try at  the  Expense  of  Other  Sections 

§  7.  Protection  as  an  Encouragement  to  Monopoly 

§  8.  Summary 

CHAPTER  VI  —  A  CONSIDERATION  OF  SOME  SPECIAL  ARGU- 
MENTS FOR  PROTECTION 116-143 

§  i.  The  Argument  that  Protection  is  Desirable  Because 
it  Keeps  Money  in  the  Protected  Country 


CONTENTS  BY  SECTIONS  xvii 

FACE 

§  2.  The  Wages  Argument  for  Protection 

§  3.  The  Make-Work  Argument  for  Protection 

§  4.  The  Home  Market  Argument  for  Protection 

§  5.  The  Argument  for  Protection  to  Agriculture  in  the 

Older   Countries,  against  a  Future   when   Cheap 

Foods  and  Raw  Material  may  not  be  Obtainable 

from  the  Newer  Countries 

§  6.  The  Infant  Industry  Argument  for  Protection 
§  7.  The  Argument  that  a  Protective  Policy  should  be 

Followed  hi  Order  to  Diversify  Industry 
§  8.  The  Argument  that  Protection  should  be  Applied  as 

a  Means  of  Getting  and  Maintaining  a  Certain 

Degree  of  National  Self-sufficiency 
§  9.  Free  Trade  within  the  United  States 
§  10.  Ethical  Considerations  Bearing  on  the  Policy  of 

Protection 
§  ii.  Summary 

CHAPTER  VII  —  THE  NATURE  AND  EFFECTS  OF  BOUN- 
TIES .  144-154 

§  i.  Bounties  as  Compared  and  Contrasted  with  Protec- 
tion 

§  2.  The  Various  Possible  Effects  of  Bounties  on  the  Level 
of  Prices 

§  3.  The  Various  Possible  Effects  of  Bounties  on  the 
General  Welfare  in  the  Bounty-paying  Country 
and  in  the  Countries  with  which  it  Trades 

§  4.  The  Various  Possible  Effects  of  Bounties  on  Wages 
and  Rent 

§  5.  Why  Bounties  may  be  Less  Objectionable  than  Protec- 
tion ii  Encouragement  of  Infant  Industries  is 
in  any  Case  to  be  Attempted 

§  6.  Summary 

CHAPTER  VIII  —  UNECONOMICAL  GOVERNMENT  INTERFER- 
ENCE WITH,  AND  ENCOURAGEMENT  OF,  TRANSPORTA- 
TION    iS5~l88 

§  i.  Navigation  Laws 

§  2.  Subsidies  to  Native  Shipping 


xviii  CONTENTS  BY   SECTIONS 

PAGE 

§  3.  Indirect  Subsidies,  Favoring  Native  Ships  as  Com- 
pared with  Foreign  Ships 

§4.  The  Free  Use  for  Navigation  of  Government-built 
Canals 

§  5.  The  Improvement  of  Harbors 

§  6.  The  Improvement  of  Rivers 

§  7.  Subsidies  to  Railroad  Building 

§  8.  Summary 


PART   I 
THE  EXCHANGE  MECHANISM  OF  COMMERCE 


INTERNATIONAL  TRADE 
AND  EXCHANGE 

CHAPTER  I 
LAWS  OF  MONEY 


Quantitative  Statement  of  the  Relation  between  Money  and 

Prices 

PRIMITIVE  trade  is  often  a  direct  trading  of  one  kind 
of  goods  for  another,  the  process  called  barter.  The 
exchange  of  knives,  hatchets,  guns,  mirrors,  etc.,  with 
the  Indians,  in  return  for  land  and  furs,  with  which  we 
have  been  made  familiar  in  our  school  histories  and  in 
stories  of  adventure,  was  trade  of  this  sort.  But  even 
the  Indians  had  wampum,  which  they  used  as  a  medium 
of  exchange,  and  the  highly  civilized  countries  have 
long  since  made  use  of  money,  whether  of  gold  or  silver 
or  other  material,  in  their  commerce.  A  study  of  the 
laws  of  commerce  involves,  then,  and  may  well  involve 
as  a  preliminary  step,  a  study  of  the  laws  of  money. 
We  are  not  likely  to  find  that  the  basic  principles  of  trade 
are  so  very  different  with  money  used  than  they  would  be 
if  the  world  traded,  supposing  it  conveniently  could, 
goods  of  one  kind  directly  for  goods  of  another.  The 


2    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

money-using  method  of  trade  is  more  efficient.  The 
motives  for  trade  and  the  nature  of  the  advantages  from 
it  are  the  same  whether  money  is  used  or  not.  But  it 
is  worth  while  analyzing  the  commercial  processes,  as 
they  are  actually  carried  on,  even  in  many  of  their  mod- 
ern complications.  To  do  so,  may  perhaps  the  more 
clearly  expose  fallacies  regarding  trade,  not  uncommonly 
held.  We  shall  begin,  then,  with  a  study  of  money, 
considered  as  an  important  part  of  the  mechanism  of 
trade. 

Money,  as  a  medium  of  exchange,  is  a  kind  of  wealth 
or  property  for  which  other  goods  are  sold  and  with 
which,  in  turn,  desired  goods  are  bought.  It  may  be 
distinguished  from  other  wealth  or  property  by  its 
characteristic  of  general  exchangeability.  A  person 
desiring,  as  all  do  desire  who  are  engaged  in  any  business 
or  regular  occupation  or  who  have  capital  to  invest,  to 
dispose  of  some  kinds  of  goods  or  services  in  exchange 
for  others,  does  not  need  to  seek  out  those  who  both  want 
what  he  has  to  sell  and  will  sell  what  he  wants  to  buy  and 
with  whom  he  can  make  a  satisfactory  trade  "in  kind." 
Instead,  he  sells  for  money,  for  a  universally  desired 
medium,  what  he  has  to  dispose  of,  to  whoever  desires 
it,  and,  with  this  money  as  purchasing  power,  seeks  out 
those  who  have  for  sale  what  he  himself  wishes  to  buy. 
The  use  of  money  is  an  intermediate  step  in  what  is  still 
the  exchange  of  goods  for  goods.  In  order  that  money 
may  perform  its  function  of  facilitating  trade,  both  goods 
to  be  sold  and  goods  to  be  bought  must  be  valued  in 
terms  of  money.  Money  becomes  a  measure  of  value 
as  well  as  a  medium  of  exchange.  One  kind  of  goods 
will  have  a  higher  value,  measured  in  money,  than  an- 
other kind;  if  its  cost  of  production  is  greater,  or  if,  for 


LAWS  OF   MONEY  3 

any  other  reason,  only  the  higher  value  will  equalize 
supply  of  and  demand  for  this  kind  of  goods.  The  same 
relation  of  values,  between  two  sorts  of  goods,  would 
exist  if  money  were  not  used,  but  the  use  of  money  makes 
it  measurable  in  a  generally  familiar  standard. 

An  analysis  of  the  prices  or  values  of  one  sort  of  goods 
as  compared  with  those  of  other  sorts,  leads  us  to  a  con- 
sideration of  the  special  forces  of  demand  and  supply, 
such  as  utility  and  cost  of  production,  acting  upon  such 
goods.  In  studying  the  laws  of  money  we  need  to  attend 
not  so  much  to  the  conditions  determining  the  value  of 
one  kind  of  goods  in  relation  to  some  other  kind  or  kinds, 
as  to  the  conditions  determining  the  average  value  of 
goods  in  relation  to  money,  and  vice  versa.  We  have  to 
consider,  that  is,  the  general  level  of  prices,  and  conversely 
the  purchasing  power  of  money. 

This  relation  between  money  and  other  goods  has  sev- 
eral times  been  given  a  mathematical  form  of  statement.1 
Let  S  represent  the  total  amount  of  money  (number  of 
dollars)  spent  in  a  given  community  during  a  given 
period  of  time,  say  a  year.  Let  M  represent  the  (average) 
number  of  dollars  in  that  community  during  the  same 
period.  Then  the  average  number  of  times  a  dollar  is 
spent  during  the  year  will  be  S/M.  This  is  the  velocity 
of  circulation  of  money  and  may  be  called  V. 
S  =  MS/Mj  and  therefore,  by  the  method  of  substi- 
tution, 5  =  M V.  In  words,  the  total  dollars  spent  for 
goods  is  equal  to  the  number  of  dollars  in  the  community 
times  the  average  velocity  of  circulation  of  those  dollars. 

But  the  total  number  of  dollars  spent  for  goods  is  also 

1  For  instance,  Newcomb,  Principles  of  Political  Economy,  New  York  (Har- 
per), 1885,  p.  346;  Edgeworth,  "Report  on  Monetary  Standard,"  Report  of  the 
British  Association  for  the  Advancement  of  Science,  1887,  p.  293;  Hadley, 
Economics,  New  York  (Putnam),  1906,  p.  197. 


4    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

equal  to  the  sum  of  the  quantities  of  all  the  kinds  of 
goods  bought,  times  their  respective  prices.  Let  the 
price  per  pound  and  the  number  of  pounds  of  sugar 
bought  be  represented  respectively  by  p  and  q,  the  price 
per  bushel  of  wheat  and  the  number  of  bushels  bought 
by  p'  and  qf,  and  so  on.  Then  the  total  number  of 
dollars  spent  for  goods,  i.e.  S,  is  equal  to  pq  +  p'q'  +  etc. 
Since  two  things  equal  to  the  same  thing  are  equal  to 
each  other,  and  since 

S  =  M  V  and  also 
S  =  pq  +  P'<l'  +  etc., 
therefore 

M  V  =  pq  +  p'q'  +  etc. 

This  is  the  mathematical  statement  of  the  so-called 
quantity  theory  of  money,  omitting,  however,  any 
reference  to  credit  currency.1  It  asserts  simply  that  the 
quantity  of  money  times  its  velocity  of  circulation,  equals 
the  prices  of  goods  bought  with  money,  times  the  quan- 
tities bought.  The  conclusion  follows,  therefore,  that 
if  the  quantity  of  money,  M,  increases,  while  the  velocity 
of  circulation  and  the  volume  of  trade  remain  the  same, 
prices  will  rise  in  the  same  proportion.  A  decrease  in 
the  amount  of  M  would,  on  the  same  assumption,  be 
accompanied  or  followed  by  a  fall  in  the  money  prices 
of  goods.  An  increase  in  the  q's  2  or  volume  of  trade 
would,  other  things  equal,  occasion  a  fall  of  prices ;  and  a 
decrease  in  the  g's,  a  rise  of  prices. 

1  For  consideration  of  credit,  see  Chs.  II  and  HI  (of  Part  I). 

'The  q's  or  quantities  of  goods  should  be  held  to  include  not  only  finished 
goods  exchanged  in  trade  and  goods  purchased  for  raw  material,  but  also  the 
additions  made  by  labor  to  the  utility  of  goods  and  paid  for  in  wages  and  the 
additions  made  by  the  service  of  "waiting"  and  paid  for  by  means  of  interest, 
dividends,  etc. 


LAWS  OF  MONEY  5 

§2 

Causal  Explanation  of  the  Price  of  a  Given  Kind  of  Goods 

A  quantitative  or  mathematical  statement  of  a  prin- 
ciple is  not,  however,  an  adequate  explanation  of  that 
principle.  In  this  case,  the  explanation  must  be  found 
in  the  working  of  the  market,  in  competition  with  each 
other  of  buyers  and  of  sellers.  This  means  that  there 
must  be  an  analysis  of  the  forces  of  supply  and  demand  in 
relation  to  general  or  average  prices,  in  addition  to  the 
usual  study  of  those  forces  in  relation  to  particular 
prices. 

The  price  of  any  particular  kind  of  goods,  say  the 
price  of  wheat  per  bushel,  is  commonly  said  to  be  fixed 
by  the  equation  of  supply  and  demand.  But  these 
terms  are  frequently  misunderstood.  For  example, 
supply  is  sometimes  thought  of  as  the  total  stock. 
Demand  is  thought  of  as  the  amount  wanted  by  pur- 
chasers, but  without  much  reference  to  the  exact  condi- 
tions determining  this  amount.  As  a  matter  of  fact, 
supply  is  not  the  total  stock  of  a  good,  whatever  relation 
it  may  have  to  this  stock.  Supply  is  different  according 
as  price  is  different.  Hence  any  reference  to  supply 
should  specify  a  price.  The  supply  of  any  good  at  a 
given  price  is  the  amount  which  sellers  are  ready  to 
dispose  of  at  that  price.1  Thus,  the  supply  of  wheat 
at  a  price  of  $1.10  per  bushel  may  be,  in  a  given  market, 
i  ,000,000  bushels.  That  is,  at  a  price  of  $i .  10  per  bushel, 
there  are  so  many  persons  ready  to  sell  wheat  and  ready 
to  sell  such  quantities,  that  1,000,000  bushels  may  be  had. 

1  See  J.  S.  Mill,  Principles  of  Political  Economy,  Book  III,  Ch.  II,  §  4- 
One  of  the  best  recent  presentations  of  the  theory  of  supply  and  demand  is  to 
be  found  in  Fisher,  Elementary  Principles  of  Economics,  New  York  (Macmillan), 
1912,  Ch.  XV. 


6    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

In  general,  the  higher  the  price,  the  larger,  other  things 
equal,  will  be  the  supply ;  and,  similarly,  the  lower  the 
price,  the  smaller  will  be  the  supply.  If  the  price  of  any 
good  is  lower  relatively  to  other  desired  goods,  producers 
and  sellers  will  be  less  inclined  to  bring  the  good  to  market 
for  disposal,  and  may  even  turn  their  attention  to  other 
lines.  If  the  price  is  higher,  they  will  be  more  inclined 
to  sell  large  quantities,  and  some  may  be  tempted  to 
forsake  other  lines  to  produce  the  good  in  question. 

In  the  same  way,  reference  to  demand  should  specify 
a  price.  Analogously,  the  demand  for  any  good  at  a 
given  price  is  the  amount  that  purchasers  stand  ready  to 
take  at  that  price.  If  at  $1.10  per  bushel  the  demand  for 
wheat  is  for  1,000,000  bushels,  then  the  number  of  per- 
sons wishing  to  buy  wheat  is  such,  and  the  amounts  they 
individually  stand  ready  to  buy  are  such,  as  to  make 
an  aggregate  of  1,000,000  bushels.  Other  things  equal, 
demand  rises  as  price  falls,  and  falls  as  price  rises.  The 
lower  the  price  of  any  good  in  relation  to  prices  of  other 
goods,  the  more  ready  are  purchasers  to  buy  it ;  and  the 
higher  the  price,  the  less  ready.  The  price  of  any  good, 
whether  of  cotton,  labor  services,  bills  of  exchange  or 
anything  else  marketable,  is  fixed  where  supply  and 
demand  are  equal. 

It  is  not,  however,  an  explanation  of  price  merely  to 
state  that  it  is  fixed  where  supply  and  demand  are  equal. 
It  is  necessary  further  to  inquire  why  price  is  fixed  at  that 
point.  If  supply  of  and  demand  for  wheat  in  a  given 
market  are  equalized  at  $1.10  per  bushel,  why  may  not 
the  price  nevertheless  be  $i  ?  If  we  assume  $i  to  be  the 
price,  we  see  that  such  a  price  represents  a  position  of 
unstable  equilibrium.  At  this  price,  the  demand  would 
be  in  excess  of  the  supply.  The  persons  anxious  to  buy 


LAWS  OF  MONEY  7 

wheat  are  ready  to  buy,  at  this  price,  more  than  can  be 
had,  and  since  even  at  $1.10  the  amounts  they  will  buy 
are  equal  to  the  amounts  they  can  get,  it  appears  that 
there  are  many  who  would  gladly  pay  more  than  $i  per 
bushel  rather  than  go  without  wheat  entirely.  Here, 
then,  are  persons,  many  of  whom  would  pay  more  rather 
than  not  get  the  wheat,  the  aggregate  of  whose  desired 
purchases  at  $i  per  bushel  must  exceed  the  total  supply 
offered.  If  $i  is  the  price,  some  who  would  gladly  pay 
that  and  more  cannot  get  the  wheat  they  desire.1  Each 
intending  purchaser  will  fear  that  he  will  be  one  of  those 
who  fail  to  get  what  they  wish.  Since  all  cannot  be 
satisfied  and  since  he  himself  may  not  be,  he  is  likely  to 
offer  more  than  $i  in  the  hope  that  sellers  will  be  per- 
suaded to  sell  to  him,  at  least.  But  he  is  not  likely  to 
offer  more  than  $1.10.  According  to  our  hypothesis, 
a  price  of  $1.10  will  bring  forth  a  supply  fully  equal  to 
the  demand.  Even  if  other  buyers  are  foolish  enough  to 
offer  a  higher  price  and  are  sold  to  in  preference,  yet  since 
the  demand  of  these  others  would  not  absorb  the  entire 
supply,  a  purchaser  who  offered  $1.10  would  secure  the 
wheat  desired. 

As  the  price  is  kept  from  going  below  that  height  which 
equalizes  supply  and  demand,  by  the  competition  of 
buyers,  so,  by  the  competition  of  sellers,  it  is  kept  from 
going  above  that  height.  If  $1.10  a  bushel  is  the  equal- 
izing price,  the  competition  of  sellers  will  prevent  the 
price  from  being  higher,  say  $1.15.  For  at  $1.15  there 
would  presumably  be  a  smaller  demand  and  a  greater 
supply.  That  is,  at  $1.15  there  would  be  sellers  anxious 
to  dispose  of,  in  the  aggregate,  more  wheat  than  buyers 

1  This  explanation  of  the  nature  of  competition  is  well  set  forth  in  Hadley, 
Economics,  pp.  75-77. 


8    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

would  take.  Some  of  these  prospective  sellers  must  be 
doomed  to  disappointment,  and  those  most  anxious  to 
sell  would  therefore  bid  against  each  other  in  lowering  the 
price  to  the  point  where  supply  and  demand  were  equal. 
This  they  would  do  because  in  no  other  way  could  they 
be  sure  of  selling  their  wheat.  But  they  need  not  go 
below  the  equalizing  price,  because  when  that  price  is 
reached  there  are  enough  more  buyers  or  enough  fewer 
sellers,  or  both,  to  insure  sales  by  those  still  in  the  market 
and  desiring  to  sell.  Even  if  some  should  offer,  unwisely, 
to  sell  at  a  lower  price,  yet  since  these  could  not,  by  our 
hypothesis,  satisfy  the  demand,  all  who  charged  the 
equalizing  price  would  still  find  purchasers.  The  market 
price  of  any  kind  of  goods,  therefore,  tends  to  be  that 
price  which  equalizes  supply  and  demand,  and  is  pre- 
vented by  the  forces  of  competition  from  going  above  or 
below  it. 

§3 

Causal  Explanation  oj  the  General  Level  of  Prices 

Let  us  now  apply  the  principles  of  supply  and  demand 
to  the  general  level  of  prices.  We  shall  see  that  much  the 
same  kinds  of  competitive  forces  which  fix  any  one  price 
(as  above  explained)  in  relation  to  other  prices,  fix  the 
general  level  of  prices  of  goods  in  terms  of  money.  We 
shall  consider,  first,  the  supply  of  goods,  including  the 
services  of  labor  and  of  "waiting"  (i.e.  investing,  or 
putting  capita]  into  use,  the  service  for  which  interest  is 
paid)  offered  for  money,  and  the  demand  for  goods  by 
those  having  money  to  spend.  Afterwards  we  can  reverse 
our  method  and  consider  the  supply  of  and  the  demand 
for  money  in  exchange  for  other  goods. 

Where  there  is  only  fiat  (inconvertible  paper)  money, 


LAWS  OF  MONEY  9 

the  supply  of  goods  in  general,  offered  for  money,  at  any 
level  of  average  prices  of  those  goods,  would  be  just  the 
same  as  at  any  other  level  of  prices.  This  is  very  nearly 
true  no  matter  what  the  money  system.1  If  wheat  prices 
are  higher  than  corn  prices,  or  vice  versa,  productive 
effort  may  be  diverted  from  one  line  into  another.  But 
we  are  now  not  discussing  changes  in  individual  or  rela- 
tive prices.  We  are  diseasing  only  changes  in  the 
general  level  of  prices,  the  average  oTpriqes.  If  the  gen- 
eral level  of  prices  should  double,  there  is  rftv  .reason  to 
believe  that  the  amount  of  goods  produced  for  sale^ould 
on  that  account  greatly  increase.  Supposing  a  com- 
munity to  be  in  reasonable  prosperity  and  business 
activity  at  the  lower  prices,  an  increase  of  these  prices 
would  not  make  possible  a  very  greatly  increased  pro- 
duction. It  would  not  enable  men  to  work  longer  hours 
nor  would  it  make  machinery  more  efficient.  Neither 
would  it  stimulate  the  sales  of  goods  by  making  such  sales 
more  profitable,  since  a  general  rise  of  prices  simply 
means  that  money  has  a  less  value.  If  everything  should 
sell  for  twice  as  much  money  as  before,  the  sellers  would 
gain  nothing,  for  the  things  they  desired  to  buy  would 
also  cost  twice  as  much.  Looking  at  the  matter  from 
any  reasonable  point  of  view,  it  must  be  admitted  that 
the  supply  of  goods  in  general,  at  a  higher  level  of  prices, 
would  be  no  greater  (or  but  slightly  greater) 2  than  at  a 
lower  level.  Likewise,  at  a  lower  level  of  prices,  the 
supply  of  goods  would  be  no  less  than  at  a  higher  one. 
A  lower  level  of  prices  would  not  mean  less  activity  or  a 
smaller  sale  of  goods.  It  would  pay  as  well  to  sell  goods 
at  a  low  level  of  prices  as  at  a  high  level,  since  at  the  lower 

1  See  remainder  of  this  section  for  explanation  of  why  it  is  not  always  entirely 
true. 

*  See  next  paragraph. 


io    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

level  the  money  received  would  have  correspondingly 
greater  purchasing  power. 

The  lower  level  of  prices  would  only  decrease  the 
supply  of  other  goods  and  the  higher  level  increase  it,  in 
one  contingency,  and  then  only  to  a  very  limited  degree. 
When  the  currency  system  is  based  on  a  precious  metal, 
e.g.  gold,  a  lower  level  of  prices  means  a  higher  value 
of  gold  as  money.  It  migh^herefore  divert  some  labor 
from  the  production  of  other  goods  to  the  production  of 
gold  for  coinage.  A  higher  level  of  prices  might  tend, 
in  the  same  degree,  to  divert  labor  from  gold  production 
towards  the  production  of  other  goods.  To  this  extent 
only,  a  higher  level  of  prices  would  tend  to  increase  the 
supply  of  goods  in  general  other  than  money,  and  a  lower 
level  of  prices  to  decrease  it. 

On  the  other  hand,  a  higher  level  of  prices  of  goods 
would  tend  to  decrease  the  demand  for  goods  by  persons 
having  money  to  spend.  For  with  higher  prices,  and  no 
greater  amount  of  money  to  spend,  buyers  of  goods  would 
be  unable  to  purchase  as  much  as  at  lower  prices.  Lower 
prices  of  goods  would  mean  that  the  money  of  purchasers 
would  go  farther. 

Let  us  now  suppose  a  doubling  of  the  amount  of  money. 
Prices  would  tend  to  increase  in  nearly  the  same  pro- 
portion. Suppose  prices  did  not  rise.  Then  purchasers 
of  goods  would  buy  all  they  were  in  the  habit  of  buying 
and  still  have  as  much  money  left  to  spend  as  they 
formerly  spent  all  together.  This  they  would  endeavor 
to  spend  at  once.  For  in  modern  countries  money  is  not 
hoarded  away,  but  only  enough  is  kept  on  hand  for 
emergency  requirements,  and  the  rest  is  spent.  Those 
who  save  are  spending  just  as  effectually  as  any  others. 
The  difference  is  in  what  they  buy.  Those  who  save 


LAWS  OF  MONEY  n 

buy  factories,  warehouses,  railroads,  farms,  etc.  Even 
though  their  savings  are  put  into  a  savings  bank,  they  are 
none  the  less  spent  for  investment  goods.  It  follows 
that  a  sudden  doubling  of  the  amount  of  money,  if  prices 
did  not  increase,  would  mean  a  demand  for  goods  far 
exceeding  the  supply.  The  amount  of  land  is  practically 
constant.  Doubling  the  amount  of  money  would  not 
enable  people  to  work  longer  hours  and  so  increase  the 
products  of  labor.  In  a  busy  community  the  supply  of 
goods  to  be  sold  simply  could  not  be  doubled  except 
with  an  increase  of  population  or  inventionx'The  in- 
creased money  would  therefore  mean  that  at  the  old 
prices  the  demand  for  goods  in  general  would  exceed  the 
supply.  Purchasers  would  bid  against  each  other. 
Prices  would  rise.  Equilibrium  would  only  be  reached, 
supply  and  demand  be  equal,  at  a  general  level  of  prices 
nearly  (or,  if  fiat  money,  quite)  twice  that  which  had 
preceded. 

If  prices  rose  equally,  this  would  mean  a  doubling  in 
the  money  wages  of  labor  for  the  same  results  produced 
and,  similarly,  a  doubling  in  the  money  interest,  dividends 
or  profits  received  for  " waiting.".  Aside  from  disturb- 
ing effects  during  the  period  of  transition,  the  rate  of 
interest -would  be  the  same  with  the  high  prices  as  with 
the  low.  The  money  value  of  the  sum  waited  for  would 
be  doubled  and  the  money  value  of  the  interest  would  be 
doubled.  The  ratio  between  them  would  be  the  same 
as  before.  In  other  words,  since  prices  have  doubled, 
borrowers,  for  example,  would  require  twice  as  many 
dollars  as  before  and  would  also,  of  course,  pay  twice  as 
many  dollars  in  interest. 

In  the  light  of  the  principles  above  set  forth,  regarding 
supply  and  demand,  we  can  explain  why  the  excessive 


12     THE  EXCHANGE  MECHANISM  OF  COMMERCE 

amounts  of  inconvertible  paper  money  sometimes  issued 
by  governments,  issued  particularly  in  time  of  war,  have 
resulted  in  very  exceptional  rises  in  the  price  level. 
This  increased  amount  of  money  means,  at  any  level  of 
prices,  a  greater  demand  for  goods.  Therefore,  that  the 
demand  for  goods  may  not  exceed  the  supply,  the  level 
of  prices  must  rise.  There  is  another  factor  of  impor- 
tance at  such  times,  viz.  public  confidence  in  the  money 
issued.  If  there  is  a  general  belief  that  the  money  will 
become  absolutely  valueless  or  greatly  decrease  in  value, 
then  many  who  have  goods  to  sell  will  refuse  to  sell  them 
for  this  money,  but  will  demand  gold  or  silver  or  other 
goods  in  exchange.  This  decrease  in  the  supply  of  goods, 
offered  for  money,  will  mean  that  only  a  higher  level  of 
prices  than  otherwise  would  result  can  equalize  supply 
and  demand.  Thus  is  to  be  explained  the  high  prices 
(and,  reciprocally,  the  great  depreciation  of  money)  in 
such  periods  as  the  American  Revolution,  the  Civil  War, 
etc. 

§4 

Causal  Explanation  of  the  Value  or  Purchasing  Power  of 
Money,  the  Reciprocal  of  the  Level  of  Prices  of  Goods 

Let  us  look  at  the  same  problem,  the  general  level  of 
prices,  from  the  other  side,  that  of  the  purchasing  power 
of  money  or  the  value  of  money  in  terms  of  goods.  We 
shall  consider  now  the  supply  of  money  offered  by 
purchasers  of  goods  (corresponding  to  demand  for  goods) 
and  the  demand  for  money  coming  from  sellers  of  goods 
(corresponding  to  the  supply  of  these  goods) . 

Before  defining  supply  of  and  demand  for  money,  we 
must  select  a  phrase  to  express  the  price  of  money.  The 
value  or  price  of  money  is  usually  expressed,  not  in  terms 


LAWS  OF  MONEY  13 

of  any  one  thing,  but  in  terms  of  all,  or  most  other, 
purchasable  goods.  Its  value  or  its  price  is  measured  in 
the  amount  of  other  goods  it  can  buy.  The  value  or 
price  of  money  we  shall  therefore  call  the  purchasing 
power  of  money. 

We  may  now  define  money  supply  and  demand  con- 
sistently with  wheat  or  coal  supply  and  demand.  First, 
as  to  supply,  we  may  say  that  the  supply  of  money  at  any 
given  purchasing  power  is  the  amount  of  money  which 
would  be  supplied  —  i.e.  would  be  offered  in  purchase  of 
goods  —  at  that  purchasing  power.  Just  as,  at  a  higher 
price  of  wheat,  the  supply  in  the  long  run  would  tend  to 
be  greater  than  at  a  lower  price,  so,  at  a  higher  purchas- 
ing power  of  money,  the  supply  of  money  would  tend  to 
be  greater  than  at  a  lower  purchasing  power.  The  supply 
would  be  greater  at  a  higher  purchasing  power,  because, 
at  a  higher  purchasing  power,  it  would  be  worth  while  to 
turn  bullion  into  coins  or  even  to  mine  more  gold  for  that 
purpose.  The  supply  of  fiat  money  (irredeemable 
paper)  would  not  be  greater,  but  would  be  just  the  same 
at  a  higher  purchasing  power  as  at  a  lower.  The  normal 
supply  of  money  at  any  purchasing  power  and  during 
any  period  of  time,  the  amount  that  would  be  offered  by 
sellers  of  money  (i.e.  buyers  of  goods)  involves,  as  Walker 
has  pointed  out,1  the  quantity  of  money  and  its  rapidity 
or  velocity  of  circulation.  This  velocity  of  circulation 
may  be  less  than  unity ;  that  is,  most  of  the  money  may 
circulate  less  than  once  if  we  are  dealing  with  an  instant 
or  a  short  period  of  time.  But  if  we  are  dealing  with  a 
long  period  of  time,  say  a  year,  and  with  the  conditions 
determining  normal  purchasing  power,  the  velocity  will 

1  Political  Economy,  Advanced  Course,  third  edition,  New  York  (Holt)  1887, 
p.  129. 


14    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

perhaps  be  20  or  more.1  In  any  case,  the  supply,  the 
amount  that  would  be  offered  at  any  given  purchasing 
power,  is  the  total  amount  which,  at  that  purchasing 
power,  would  be  on  hand,  multiplied  by  its  velocity; 
and  it  may  be  represented,  therefore,  as  M  V. 

Turning  to  the  subject  of  demand,  we  may  properly 
define  the  demand  for  money,  at  any  purchasing  power, 
as  the  amount  of  money  that  would  be  taken  by  sellers 
of  goods,  at  that  purchasing  power.  The  demand  for 
money  comes  from  the  sellers  of  other  goods  who  wish 
to  take  money  in  exchange  for  those  goods.  They  may  be 
said  to  buy  money  with  the  goods  they  sell.  When  the 
money  is  altogether  fiat  (inconvertible  paper)  money, 
the  amount  of  goods  offered  for  money  will  not  be  affected 
by  the  purchasing  power  of  money.  With  an  exception 
shortly  to  be  noted,  this  is  also  true  in  the  case  of  such  a 
commodity  money  as  gold  or  silver.  That  the  purchas- 
ing power  is  at  any  time  greater  or  less,  provided  only  it  is 
not  fluctuating,  affects  neither  for  good  nor  ill  the  sellers 
of  goods.  If  the  purchasing  power  of  money  is  greater, 
they  will  still  sell  their  goods  as  readily  for  money  since 
the  smaller  amount  of  money  so  received  will  go  as  far 
as  would  a  larger  amount  having  a  smaller  purchasing 
power  per  unit  (e.g.  per  dollar).  But  their  demand  for 
money,  in  the  proper  use  of  the  term  "  demand,"  will 
not  be  the  same.  If  the  purchasing  power  of  money  is 
doubled,  demand  for  money  will  be  exactly  halved.  If 
the  purchasing  power  of  money  is  halved,  demand  for 
money  will  be  doubled.  Sellers  of  goods  will  take  all  the 
money  which  the  goods  they  desire  to  sell  will  bring. 
If,  therefore,  the  purchasing  power  of  money  is  halved, 

1  See  Fisher,  The  Purchasing  Power  of  Money,  New  York  (Macmillan),  1911, 
p.  290. 


LAWS  OF  MONEY  15 

i.e.  if  it  takes  twice  the  former  amount  of  money  to  buy 
the  same  goods,  then  the  demand  for  money,  the  amount 
sellers  of  goods  (buyers  of  money)  will  take,  at  this  pur- 
chasing power,  will  be  exactly  doubled.1 

The  exception  to  be  noted  has  already  been  referred 
to  in  the  discussion  of  the  general  level  of  prices.2  It  oc- 
curs when  money  is  based  on  some  standard  commodity, 
as  gold,  having  an  appreciable  cost  of  production.  To 
double  the  purchasing  power  of  money  would,  in  fact, 
probably  reduce  the  demand  for  it  to  something  very 
slightly  less  than  half  what  it  had  been,  for  a  small  (rela- 
tively a  very  small)  amount  of  labor  would  probably  be 
diverted  from  the  production  of  other  goods  to  the  mining 
of  gold.  Therefore,  unless  the  value  of  money  more  than 
doubled  (i.e.  unless  money  prices  of  goods  became  less  than 
half),  the  money  which  would  be  taken  by  sellers  of  the 
somewhat  smaller  stock  of  goods  would  be  less  than  half 
as  great.  Similarly,  a  fall  of  half  in  the  value  of  money 
would  very  probably  divert  some  labor  from  gold  mining 
into  other  lines,  and  so  might  slightly  more  than  double 
the  demand  for  money.  For  every  one  would  be  ready 
to  sell  his  goods  at  twice  the  former  price,  and  there  would 
be  more  goods  to  sell.  Normal  demand,  therefore,  for 
money,  i.e.  long-run  demand,  cannot  be  distinguished  by 
any  exact  proportion  from  demand  for  other  goods. 
But  when  the  money  does  not  involve  an  appreciable  cost 
of  production,  but  is  inconvertible  paper,  or,  for  any 
money,  where  an  extremely  short  period  is  involved,  the 
demand  for  money  varies  inversely  with  its  purchasing 
power. 

1  Were  it  not  for  the  exception  next  to  be  mentioned,  the  demand  curve  for 
money  would  be  always  a  rectangular  hyperbola, 

2  §  3  of  this  chapter  (I  of  Part  I). 


16    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

The  demand  for  money  by  sellers  of  goods  may  be  said 
to  be  the  money  value  at  which  they  would  sell  those 
goods ;  therefore,  the  prices  times  the  quantities ;  there- 
fore, pq  +  p'q'  +  etc.  The  purchasing  power  of  money 
is  fixed  where  supply  is  equal  to  demand,  where 
MV  =  pq  +  p'q'  +  etc.  The  equation  of  exchange  may 
be  regarded  as  simply  a  mathematical  mode  of  stating 
that  the  p's,  the  purchasing  power  of  money,  must  be 
such  that  supply  of  money  equals  demand,  i.e.  that 
M  V  =  pq  +  p'q'  +  etc. 

§5 
The  Theory  of  Bimetallism 

The  laws  of  supply  and  demand  serve  to  explain  the 
effects  of  the  various  monetary  systems  which  have  been 
tried  in  different  countries.  Important  among  those 
monetary  systems  is  bimetallism.  Bimetallism  involves 
the  concurrent  circulation  of  two  metals  at  a  fixed  legal 
ratio.  Both  metals  are  coined  by  government,  for  those 
bringing  the  metals  to  the  mints,  in  any  desired  quantity, 
and  coined  without  charge  or  for  the  mere  cost  to  gov- 
ernment of  coining.  Both  metals,  when  so  coined,  are 
legal  tender  for  the  payment  of  debts  and  taxes,  at  the 
value  ratio  fixed.  Thus,  bimetallism  at  16  to  i  meant, 
for  the  United  States,  that  the  amount  of  silver  in  the 
silver  dollar  should  be  approximately  16  times  the  amount 
of  gold  in  a  gold  dollar,  that  gold  and  silver  should  both 
be  coined  freely  and  without  limit,  and  that  a  debtor 
should  be  able  to  liquidate  the  same  debt  with  100  silver 
dollars  as  with  100  gold  dollars. 

Bimetallism  may  succeed  if  the  legal  ratio  is  not  too  far 
from  the  market  ratio  of  values  existing  when  the  system 


LAWS  OF  MONEY  17 

is  started.  If  the  amount  of  silver  in  the  legal  silver  dollar 
is  worth  98  per  cent  as  much  as  the  gold  in  the  gold  dollar, 
or  98  cents,  then  the  system  may  succeed.1  It  will 
succeed  because  the  possibility  of  using  98  cents'  worth  of 
silver,  if  coined,  to  pay  a  $i  debt  (or  tax)  previously 
payable  in  gold,2  will  stimulate  the  coinage  of  silver. 
This  extra  demand  for  silver  will  increase  its  value. 
Otherwise  expressing  the  matter,  we  may  say  that  the 
withdrawal  of  silver  from  the  arts,  tending  to  cause  a  de- 
creased supply  of  silver  for  arts  uses,  will  increase  its  value. 
The  greater  quantity  of  money  will  tend  to  make  some- 
what higher  prices  and  a  somewhat  lower  value  of  a  dollar 
(whether  gold  or  silver).  This  may  discourage  the  coin- 
age of  gold  or  even  cause  the  melting  of  some  gold  coin 
into  bullion.  We  may  say  that  the  less  demand  for  gold 
has  made  its  value  fall,  or  that  the  melting  of  gold  coin 
and  the  consequent  greater  supply  of  gold  in  the  arts  has 
made  its  value  fall.  The  sequence  is,  then,  flow  of  silver 
from  bullion  into  coin,  slightly  depressed  value  of  coin, 
flow  of  gold  from  coin  into  bullion.  Silver  has  risen  in 
value.  Gold  has  fallen.  Probably  the  silver  dollar  is, 
therefore,  now  worth  the  same  as  the  gold  dollar  instead 
of  98  per  cent  as  much.  If  the  bullion  content  of  the  gold 
dollar  came  to  be  of  the  less  value,  debtors  would  prefer 
to  coin  gold  and  the  flow  would  be  in  the  opposite  direc- 
tion, but  likewise  towards  the  establishment  of  equilib- 
rium. 

Suppose,  however,  that  the  amount  of  silver  in  a  silver 
dollar  is  worth  only  40  per  cent  of  the  gold  dollar  (which 
was  more  nearly  the  case  with  the  silver  dollar  when  its 

1  Cf.  Fisher,  Elementary  Principles  of  Economics,  pp.  230,  231. 

2  Or  money,  on  a  parity  with  the  gold,  other  than  silver  money  coined  for 
account  of  the  debtor. 


i8    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

free  coinage  was  advocated  in  1896).  Then  the  danger 
would  be  that,  long  before  the  increased  demand  for  silver 
as  money  and  its  decreased  supply  in  the  arts,  coupled 
with  the  decreased  demand  for  gold  as  money  and  its 
increased  supply  in  the  arts,  had  brought  about  the 
desired  equilibrium  of  value,  the  gold  would  be  entirely 
driven  out  and  the  money  used  would  simply  be  silver 
instead  of  gold.  The  whole  question  would  be  whether 
the  scarcity  of  silver  in  the  arts  and  the  plentifulness  of 
gold  in  the  arts  would  be  sufficiently  marked  to  make 
the  relative  values  the  same  as  in  the  legal  ratio,  before 
silver  enough  had  been  taken  from  the  arts  uses  to  fill 
all  the  money  circulation ;  and  then,  whether  sufficient 
additional  supplies  of  silver  could  be  got  from  the  mines 
to  drive  out  the  gold  without  forcing  the  margin  of  pro- 
duction unprofitably  low,  i.e.  without  mining,  at  a  loss, 
from  poor  mines. 

For  one  country  alone,  the  prospects  of  success  in  es- 
tablishing bimetallism  would  be  much  less  bright  than 
for  a  group  of  important  commercial  countries.  For  if 
one  country  tried  it  alone,  endeavoring  by  free  coinage 
to  make  40  cents'  worth  of  silver  equal  to  $i  worth  of 
gold,  it  would  have  to  absorb  into  its  currency,  not  only 
silver  from  within  its  own  borders,  but  silver  flowing  to 
it  from  all  the  world,  and  its  own  demand  in  relation  to 
such  a  great  supply  might  increase  the  value  of  silver 
relatively  little.  And,  as  the  silver  drove  out  the  gold, 
the  latter  would  not  fall  rapidly  in  value  through  con- 
gesting the  arts,  but  would  be  distributed  to  the  money 
supplies,  as  well  as  the  arts,  of  all  other  countries. 


LAWS  OF  MONEY  19 

§6 

The  Value  of  Subsidiary  Money 

At  the  present  time,  in  the  United  States,  France,  and 
elsewhere,  there  exists  the  so-called  limping  standard, 
i.e.  there  are  silver  coins  the  bullion  value  of  which  is  not 
equal  to  their  face  value,  but  the  amount  of  which  is 
strictly  limited.  In  the  United  States,  there  are  a  cer- 
tain number  of  silver  dollars  and  silver  certificates.  The 
silver  in  the  silver  dollars  is  worth  perhaps  about  half  of 
their  face  value.  But  they  cannot  drive  out  gold  because 
not  enough  are  coined  to  produce  such  a  result.  Any 
money,  even  paper,  if  put  forth  in  very  limited  quantities 
and  made  legal  tender  for  the  payment  of  debts  and  taxes, 
may  circulate  at  par  with  gold.  The  possibility  of  using 
it  for  debts  and  taxes  creates  a  demand  for  it,  and  others 
will  take  it  because  they  in  turn  can  pass  it  to  those  hav- 
ing such  uses  for  it.  A  general  public  confidence  in  and 
willingness  to  take  it  at  the  legal  value,  is  developed. 
On  the  other  hand,  the  limitation  of  its  quantity  means 
a  limited  supply.  The  demand  for  it  equals  this  supply, 
at  a  value  equal  to  par.  Where  a  limited  amount  of 
money  is  issued  by  coining  metal  of  less  value  than  the 
money,  or  by  printing  paper,  this  is  done  by  government 
exclusively  on  its  own  account.  Otherwise  there  would 
be  special  favor  shown,  at  the  general  expense,  to  those 
persons  for  whom  the  coining  was  done. 

Making  paper  or  other  money  redeemable  in  gold  is 
merely  a  way  of  making  the  forces  of  demand  and  supply 
automatic  in  keeping  up  the  value  of  such  credit  money.1 
If  for  any  reason,  e.g.  overissue  or  lack  of  confidence,  the 
value  of  such  money  sinks  below  the  value  of  the  gold 

1  Cf .  Fisher,  The  Purchasing  Power  of  Money,  pp.  262-263. 


20    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

in  which  it  is  redeemable,  the  holders  of  the  paper  money 
at  once  present  it  in  large  quantities  for  redemption. 
This  immediately  decreases  the  supply  of  it,  and  thus 
automatically  prevents  its  entire  driving  out  of  gold. 
Prompt  redemption  at  the  same  time  gives  confidence 
and  so  maintains  a  demand  for  it.  But  the  limitation 
of  supply,  automatic  or  otherwise,  is  important,  for  no 
amount  of  confidence  can  prevent  a  fall  in  the  value  of 
money  which  increases  indefinitely  in  quantity.  An 
increase  in  gold  itself  tends  to  raise  prices  and  lower 
the  value  of  gold.  An  increase  of  paper  money  tends 
to  increase  prices  in  paper.  Redeemability  prevents 
prices  in  paper  from  ever  rising  higher  than  prices  in 
terms  of  gold. 

In  the  case  of  paper  money,  the  receiver  is  really  a 
creditor.  He  gets  a  credit  claim,  not  real  wealth.  The 
paper  money  evidences  a  right  based  on  its  general 
acceptability,  or  on  its  redeemability  by  government,  to 
an  amount  of  wealth  or  income  services  equal  to  the 
value  of  the  money.  The  issue  of  paper  money  is  a 
species  of  borrowing  by  government ;  but  no  interest  is 
paid,  because  the  holder,  unlike  the  holder  of  government 
bonds,  has,  if  the  money  is  generally  acceptable,  a  demand 
claim.  He  does  not  need,  therefore,  to  wait  for  his 
desired  goods  any  longer  than  he  wishes  to,  but  can  spend 
the  money  and  get  goods  at  any  time  from  another,  who 
can  do  likewise  with  a  third,  etc.  He  does  not  need,  there- 
fore, to  be  in  the  position  of  a  creditor  longer  than  his 
own  convenience  dictates.  The  general  acceptability 
of  such  money,  if  it  is  generally  acceptable,  makes  the 
holder  willing  to  forego  any  other  interest.1 

The  money  of  the  United  States  includes  gold  and  silver 

1  See  Ch.  II  (of  Part  I),  §§  3,  4- 


LAWS  OF  MONEY  21 

coins,  gold  certificates,  silver  certificates,  United  States 
notes  (greenbacks),  treasury  notes,  and  subsidiary  coins 
(quarters,  dimes,  etc.).  There  are  also  bank  notes,  but 
these  may  be  better  considered,  along  with  other  bank 
credit,  in  the  next  chapter.  All  the  paper  money  except 
silver  certificates  is  redeemable  by  law  in  gold.  Silver 
certificates  are  redeemable  in  silver.  No  law  expressly 
makes  the  silver  dollars  redeemable  in  gold ;  but  it  is 
the  duty  of  the  Secretary  of  the  Treasury  to  maintain  the 
parity  of  the  silver  coinage  with  gold,  and  in  practice  any 
kind  of  our  money  is  exchangeable  at  the  United  States 
Treasury  for  any  other  kind.  Even  without  this  prac- 
tice, the  limitation  on  the  number  of  silver  dollars  and 
their  full  legal  tender  quality  would  doubtless  maintain 
them  at  par  value,  although  the  value  of  the  contained 
bullion  is  much  less. 

§7 

The  Value  of  Money  as  Related  to  the  Value  of  a  Standard 
Money  Metal 

Most  countries  have  now  the  gold  standard.  All 
money  is  redeemable  in  or  in  some  way  related  to  gold, 
and  the  value  of  money  tends  to  equal  the  value  of  the 
mint  equivalent  in  gold.  So  long  as  gold  is  coined  freely, 
and  in  any  quantity  desired,  into  money,  the  value  of 
gold  as  money  and  as  bullion  must  be  the  same.  For 
if  gold  coin  came  to  have  more  value  than  gold  bullion 
to  be  used  in  the  arts,  then  persons  having  gold  bullion 
would  hasten  to  get  it  coined.  The  consequent  increase 
of  money  would  raise  the  prices  of  goods  and  lower  the 
value  of  money.  The  decrease  of  gold  for  use  in  the  arts 
would  increase  its  value  in  that  use.  Equal  value  in  the 
two  uses  must  soon  be  reached.  If,  on  the  other  hand, 


22     THE  EXCHANGE  MECHANISM  OF  .COMMERCE 

gold  as  money  should  have,  at  any  time,  a  less  value  than 
the  same  amount  of  gold  as  bullion,  then  all  newly  mined 
gold  would  be  used  in  the  arts  and  little  or  none  coined, 
until  gold  in  the  arts  was  so  plentiful  and  money  so  scarce 
as  to  make  the  values  even  again.  Gold  money,  if  full 
weight,  might  even  be  melted  into  bullion,  if  it  were 
worth  enough  more  in  the  latter  use  to  pay  for  the 
trouble. 

Eventually,  then,  since,  when  the  gold  standard  is  in 
force,  the  value  of  money  and  the  value  of  gold  bullion 
tend  to  be  the  same,  both  depend  upon  the  amount  of 
gold  mined  relative  to  the  use  for  it.  The  cost  of  pro- 
duction of  gold,  and,  therefore,  the  number  and  richness 
of  gold  mines,  is  not  without  an  influence,  in  the  last 
analysis,  on  the  level  of  prices,  and  on  its  reciprocal, 
the  purchasing  power  of  money.1 

§8 

The  Level  of  Prices  and  the  Value  of  Money  in  One 
Country  or  Locality  as  Related  to  the  Level  of  Prices 
and  the  Value  of  Money  in  Another 

Before  concluding  this  chapter,  something  should  be 
said  regarding  the  relation  of  the  quantity  of  money  and 
prices  in  one  locality  or  country  to  the  quantity  of  money 
and  prices  in  others.2  The  subsidiary  and  credit  money 
of  one  country  is  commonly  not  received  in  other  countries. 
Gold  or  silver  (at  present,  with  the  gold  standard  general, 
chiefly  gold)  is  passed  from  one  country  to  another  in 
payment  for  goods  or  services  or  to  redeem  obligations. 

1  These  facts  are  mechanically  expressed  in  Fisher,  The  Purchasing  Power  of 
Money,  pp.  96-111. 

1  For  a  fuller  statement  see  Fisher,  The  Purchasing  Power  of  Money,  pp.  90- 
96. 


LAWS  OF  MONEY  23 

Between  different  countries,  the  gold  passes  only  by 
weight,  but  since  gold  coin  and  bullion  are  related  in  all 
gold  standard  countries,  the  effect  of  the  flow  of  gold  from 
one  country  to  another  is  to  decrease,  relatively,  the 
quantity  of  money  in  the  one  and  to  increase  it,  rela- 
tively, in  the  other.  Between  parts  of  the  same  nation, 
all  legal  tender  money,  whether  gold,  silver,  or  paper, 
passes  freely. 

What  are  the  laws  of  this  flow?  Obviously,  money, 
like  all  things  else,  flows  to  those  places  where  it  has  the 
greatest  value,  where  it  can  buy  the  most  of  other  things. 

I  That  is,  money  flows  from  those  places  or  countries  where 
prices  of  goods  are  high,  to  those  places  or  countries 
where  prices  are  low.  Goods  are  bought  where  they  can 
be  bought  the  cheapest.  Money  goes  to  pay  for  the 
goods.  Hence,  money  flows  to  those  places  where  there 
are  low  prices.  But  low  prices  means  high  purchasing 
power  or  value  of  money.  Therefore  money  flows  to 
those  places  where  its  value  is  high.  When,  however, 
one  country  has  an  inconvertible  paper  money  unrelated 
to  the  money  of  another,  no  such  flow  can  take  place. 
When  paper  money  is  first  issued  in  one  country  it  tends, 
by  raising  prices,  to  cause  purchases  abroad,  where 
prices  have  not  thus  been  raised.  As  the  paper  money 
is  not  legal  tender  elsewhere,  gold  must  be  sent  to  pay 
for  the  goods  thus  bought.  The  continuing  issue  of 
paper  money  may  drive  all  the  gold  out  of  the  currency 
of  the  country  issuing  the  paper.  Until  it  does  so,  the 
effect  on  prices  applies  to  other  countries  as  well ;  the 
effect  is  distributed  over  all.  Though  the  paper  circu- 
lates only  in  the  issuing  country,  it  displaces  gold  and 
pushes  the  gold  into  other  countries.  But,  when  enough 
paper  money  has  been  issued  completely  to  drive  out 


24     THE  EXCHANGE  MECHANISM  OF  COMMERCE 

gold,  no  such  further  effect  on  other  countries  can  be 
produced.  Trade  will  still  take  place.1  Commodities  of 
one  sort  are  bought  and  commodities  of  another  sort 
are  sold.  Gold  itself  maybe  traded  back  and  forth.  But 
the  currency  of  the  one  country  is  absolutely  unrelated 
to  the  currencies  of  others. 

§9 

Summary 

In  this  chapter  we  have  been  concerned  chiefly  with 
the  laws  of  money,  an  important  part  of  the  mechanism 
of  civilized  commerce.  We  saw,  first,  that  the  general 
level  of  prices  of  goods  varies,  other  things  equal,  with 
the  quantity  of  money.  This  fact  was  mathematically 
expressed  in  the  so-called  "  equation  of  exchange," 

MV=_pq  +  p'q'  H-etc. 

Analysis  of  the  causal  relations  between  quantity  of 
money  and  prices  led  us  to  demand  and  supply  and  the 
ordinary  forces  of  competition  as  an  explanation.  It 
was  seen  that  increased  money  involves  higher  prices  of 
goods  to  equalize  supply  of  and  demand  for  those  goods, 
and,  conversely,  a  lower  purchasing  power  or  value  of 
money,  to  equalize  supply  of  and  demand  for  that  money. 
Supply  of  money  might  be  determined  by  government  in 
the  case  of  inconvertible  paper  but  is  generally  a  matter 
of  the  production  of  the  precious  metals,  especially  gold. 
The  possibility  of  successful  bimetallism  was  shown  to 
depend  upon  the  ratio  chosen  and  the  relative  amounts  of 
money  of  each  metal  available  under  that  ratio.  Supply 
and  demand  acting  through  the  money  and  bullion 
markets  tend  to  bring  market  ratio  to  equivalence  with 

1  See  Ch.  VI  (of  Part  I),  §§  7,  8. 


LAWS  OF  MONEY  25 

legal  ratio,  but  may  not  have  the  effect  of  doing  this 
before  one  metal  is  driven  out  of  circulation.  The 
limping  standard  and  paper  money  were  shown  to  depend 
upon  limited  quantity  of  the  paper  money  or  the  over- 
valued (in  comparison  to  weight)  silver  (or  other  metallic) 
money,  and  upon  their  legal  tender  qualities.  The 
supply  is  limited ;  the  demand  kept  up.  Redeemability 
automatically  tends  to  prevent  oversupply  of  credit 
money  or  that  loss  of  confidence  which  decreases  demand 
for  the  money.  With  free  coinage  of  gold,  the  value  of 
gold  as  coin  and  as  bullion  tends  to  be  the  same.  Finally, 
we  saw  that  the  flow  of  money  from  place  to  place  or 
country  to  country  is  a  flow  from  where  it  is  cheap  to 
where  it  is  dear,  from  where  it  buys  little  to  where  it  buys 
much,  from  where  prices  of  goods  are  high  to  where  they 
are  low. 


CHAPTER  II 

THE  NATURE  OF  BANK  CREDIT 

§i 

How  and  When  Credit  Takes  the  Place  of  Money 

CREDIT  is  given  whenever  goods  are  sold  for  a  promise 
to  pay,  for  a  tacit  obligation  to  pay  later,  or  for  some 
form  of  claim  upon  a  third  party  such  as  a  bank.  The 
characteristic  of  all  credit  is  the  fact  that  the  person 
disposing  of  goods  to  another  does  not  immediately 
receive  payment  in  the  form  in  which  he  is  entitled, 
ultimately,  to  receive  it ;  but  receives,  instead,  a  right  to 
future  payment,  a  right  commonly  evidenced  by  some 
kind  of  commercial  paper.  Most  frequently  this  evidence 
is  the  check  on  a  bank,  showing  the  title  of  the  receiver 
or  payee  to  money  from  the  bank  on  demand ;  or  the  bill 
of  exchange,  showing  a  title  of  the  payee  to  money  from 
the  drawee,  sometimes  on  demand  and  sometimes  on  a 
definitely  agreed  date. 

The  term  "currency"  we  shall  use  generically  to  in- 
clude money,  which  is  generally  acceptable  in  exchange 
for  other  goods,  and  those  credit  rights,  less  generally 
acceptable,  which  are,  nevertheless,  largely  used  as  media 
of  exchange  and  therefore  serve  as  money  substitutes. 
Such  credit  instruments  as  checks,  bills  of  exchange,  and 
promissory  notes,  act  as  substitutes  for  money  only  if  the 
rights  to  the  sums  which  they  have  reference  to  are  trans- 
ferred to  third,  fourth  and  other  parties.  Only  in  such 

26 


THE  NATURE  OF  BANK  CREDIT  27 

cases,  therefore,  can  these  credit  instruments  or  the  rights 
which  they  certify  be  considered  as  currency.  If  a  prom- 
issory note  is  given  by  one  person  to  another  and  kept 
by  the  second  until  maturity,  the  use  of  the  note  merely 
means  that  money  is  paid  from  the  one  person  to  the 
other  at  a  later  date  instead  of  an  earlier.  There  is  no 
saving  of  the  use  of  money  in  the  sense  that  credit  takes  its 
place.  But  if  A  owes  B  $100  and  B  owes  C  the  same  sum, 
and  if  A's  promissory  note  to  B  is  used  by  the  latter  to 
pay  C,  then  the  use  of  money  is  to  some  extent  avoided. 
A  eventually  redeems  his  note  by  paying  C  the  money. 
Money  is  passed  once  instead  of  twice. 

The  ordinary  check,  sometimes  called  the  "customer's 
check,"  is  similarly  used.  A  may  give  to  B  a  check  for 
$100.  B,  though  he  does  not  perhaps  use  the  same  check 
to  pay  C,  uses  the  same  demand  right  or  claim  on  the 
bank.  He  sends  in  the  first  check  and  has  it  credited  to 
his  account.  Then  he  gives  his  own  check  to  C.  C 
may  collect  from  the  bank  or  may  in  turn  pay  a  fourth 
party  by  check,  and  so  on.  In  practice,  the  sums  owed 
by  the  different  parties  will  probably  not  exactly  balance. 
B  may  pay  C  by  giving  the  latter  a  check  evidencing  the 
right  to  draw  the  sum  received  by  B  from  A  plus  other 
sums  received  by  B  from  D,  E,  F,  etc.  But  however 
this  may  be,  the  principle  is  the  same.  Thus,  the  bank 
deposit,  or  right  to  draw  from  a  bank,  takes  the  place  of 
money  in  effecting  exchanges  of  goods  or  services.  The 
use  of  bills  of  exchange  also  facilitates  the  balancing 
off  of  obligations  against  each  other,  without  the  payment 
of  coin.1 

i  See  Ch.  IH  (of  Part  I),  §  i. 


28    THE  EXCHANGE  MECHANISM  OF  COMMERCE 


How  Commercial  Banking  is  Carried  On 

Credit  instruments,  or  credit  rights  —  for  the  paper  is 
in  each  case  but  evidence  of  the  underlying  obligation  — 
act  as  substitutes  for  money  primarily  through  the  inter- 
mediation of  commercial  banking,1  and  foreign  exchange 
banking.  Commercial  banks  constitute  an  important 
part  of  the  mechanism  of  trade.  Their  work  facilitates 
internal  trade  and,  in  connection  with  the  work  of  foreign 
exchange  banks  and  brokers,  facilitates  external  trade 
as  well.  It  is  estimated  that  nine  tenths  of  the  total 
business  in  the  United  States  is  carried  on  through  the 
use  of  bank  credit.2 

Bank  deposits  (rights  to  draw  from  a  bank  or  banks), 
which  circulate  by  means  of  checks,  may  come  into  being 
in  any  one  of  several  ways.  One  may  become  a  de- 
positor by  directly  depositing  money  (or  the  right  to  draw 
money,  received  by  check  from  some  one  else,  but  this 
merely  registers  a  transfer  of  a  deposit  and  does  not 
create  one)  .  One  may  become  a  depositor  by  borrowing 
from  the  bank  in  which  the  deposit  is  to  be.  If  A  goes 
to  his  bank  and  leaves  there  $50,000  cash,  he  thereupon 
is  said  to  have  deposited  such  an  amount  in  the  bank 
and  can  draw  on  this  sum  at  will  by  issuing  checks  against 
it  in  favor  of  any  persons  to  whom  he  wishes  to  make 
payments.  But  A  may  also  go  to  the  same  bank,  give 
his  endorsed  note  or  other  satisfactory  security,  and  bor- 
row $50,000.  This  money  he  leaves  on  deposit.  The 
bank  is  then  said  to  lend  its  credit.  What  A  has  bor- 

1  Savings  banks  and  investment  banks  perform,  of  course,  important  functions, 
but  do  not  have  a  part  in  providing  a  substitute  for  money. 

2  See  Fisher,  The  Purchasing  Power  of  Money,  New  York  (Macmillan),  191  1, 
pp.  317,  3i8. 


THE  NATURE  OF  BANK  CREDIT  29 

rowed  is  not  money  but  the  right  to  draw  money  by  check, 
at  will.  The  bank  is  under  as  much  obligation  to  redeem 
his  checks  on  demand  as  if  he  had  directly  put  money 
into  the  bank.  On  the  other  hand,  A  is  under  obligation 
to  pay  the  bank,  when  his  note  matures,  the  amount 
borrowed  plus  interest. 

It  should  be  readily  apparent  that  a  bank  can,  in  ordi- 
nary times,  redeem  all  checks  presented  for  redemption, 
without  keeping  for  that  purpose  a  cash  reserve  which 
at  all  nearly  equals  its  liabilities.  The  total  value  of 
deposits  which  a  bank  is  under  obligation  to  pay  out  on 
demand,  may  be  $500,000.  Yet  it  is  certain  that  all  the 
depositors  will  not  call  for  their  money  at  the  same  time. 
Instead  of  drawing  it  out,  most  of  them  send  checks  back 
and  forth  to  and  from  others  who  do  likewise.  A  cash 
•reserve  of  $100,000  may  be  ample.  Putting  the  matter 
iri '  the  opposite  way,  we  may  assert  that  if  there  is 
$100,000  in  cash  in  such  a  bank,  the  bank  can  lend  its 
credit,  i.e.  more  deposits  or  rights  to  draw,  to  the  extent 
of  (say)  $400,000. 

We  have  said  that  different  depositors  in  a  bank  liqui- 
date their  obligations  to  each  other  by  giving  checks. 
There  is,  then,  simply  a  change  on  the  bank's  books. 
Any  amount  of  obligations  can  be  thus  balanced.  Dif- 
ferent persons  are  made  successively  creditors  of  the  bank 
for  larger  or  smaller  sums/  The  situation  is  complicated, 
but  the  principle  is  not  changed,  when  depositors  of  dif- 
ferent banks  have  business  dealings  with  each  other. 
In  this  case,  which  is  a  decidedly  usual  one,  the  banks 
become  successively  each  other's  debtors  and  creditors 
and  have  to  settle  through  a  clearing  house.  Bank  A 
may  have  accepted  and  paid  cash  for,  or  credited  to 
depositors,  many  checks  on  Bank  B.  Bank  B  therefore 


?$>•  THE.  EXCHANGE  MECHANISM  OF  COMMERCE 

owes  Bank  A.  Similarly,  Bank  C  may  owe  Bank  B,  etc. 
All  of  these  complicated  obligations  are  balanced  by  a 
clearing  house,  so  that  each  bank  pays  what  it  owes  net 
or  receives  what  is  owed  to  it  net,  and  a  great  deal  of  flow 
of  money  is  avoided.  In  other  words,  the  principle  of 
cancellation  is  applied  whenever  possible  between  banks, 
just  as  it  is  in  any  one  bank  to  the  depositors  in  it. 

§3 

Analysis  of  Relations  Involved  in  Commercial  Banking 

But  our  analysis  of  the  nature  of  commercial  banking 
is  not  complete  until  we  go  back  of  the  banks  and  examine 
the  relations  to  each  other,  through  the  banks,  of  those 
who  deal  with  the  banks  and  with  each  other.1 

When  a  man  borrows  from  a  bank  (giving  propej 
curity  and  receiving  credit  on  the  bank's  books), 
getting  command  over  present  wealth  in  return  for  a 
promise  to  repay  wealth  in  the  future.  Those  who  pro- 
vide him  with  this  present  wealth  must  wait  before  being 
repaid.  Lending  always  involves  giving  up  something 
now  and  getting  something  in  the  future,  i.e.  lending 
always  involves  waiting.2  In  order,  then,  that  any  one 
may  borrow  from  a  bank,  some  person  or  persons  must  be 
the  lenders,  must  be  ready  to  give  up  goods  in  the  present 
for  goods  in  the  future,  must  provide  waiting.  The  bank 
itself  is,  for  the  most  part,  only  an  intermediary.  It 
brings  together  a  supply  of  waiting,  but  it  does  not,  to 
any  considerable  extent,  furnish  that  supply.  It  places 

1  The  argument  of  this  and  the  following  section  is  substantially  the  same  as 
that  presented  by  the  writer  in  the  Quarterly  Journal  of  Economics,  August,  1910, 
in  an  article  entitled  "Commercial  Banking  and  the  Rate  of  Interest." 

1  Though  there  may  also  be  waiting  where  there  is  no  lending  but  only  in- 
vesting. 


THE  NATURE  OF  BANK  CREDIT  31 

loanable  funds  at  the  disposal  of  borrowers,  but  it  is  not 
itself  the  ultimate  lender. 

The  persons  who  provide  the  waiting,  i.e.  who  are  the 
real  lenders,  may  be  divided  into  two  classes:  (a) 
those  who,  in  return  for  goods,  receive  checks  from 
borrowers  of  the  banks  (or  personal  notes  or  "ac- 
ceptances," which  the  banks  discount1),  (b)  Those 
who  have  deposited  money  in  the  banks. 

Both  of  these  classes  have  claims  on  the  lending  banks, 
claims  which,  taken  all  together,  cannot  be  redeemed 
by  the  banks  except  as  those  who  have  borrowed,  those 
who  are  indebted  to  the  banks,  make  good  the  claims  of 
the  banks  on  them.  When  a  man  has  accepted  a  check 
from  one  who  has  borrowed  of  a  bank,  and  has  given 
in  exchange  for  this  check,  he  has  actually  given 
jnt  wealth  in  exchange  for  a  mere  right  to  draw  on  the 
fank.  He  may,  therefore,  so  long  as  he  does  not  exercise 
this  right,  be  regarded  as  a  lender.  If  he  passes  a  check 
for  a  like  amount  to  another,  in  return  for  goods,  the 
other  becomes  the  lender,  since  this  other  now  has  the 
right  to  draw,  and  has  given  up  for  it  present  wealth. 
If,  instead  of  passing  a  check  to  another,  the  original 
payee  avails  himself  of  this  right  to  draw,  taking  money 
from  the  bank,  then  some  one  who  has  deposited  cash 
in  the  bank  vaults  may  be  looked  upon  as  the  lender, 
since  his  money  has  been  taken  from  the  bank  and  the 
borrower  is  expected  to  make  good  the  subtraction. 
Thus,  either  the  original  receiver  of  a  deposit  right  from 
a  borrower,  or  some  one  to  .whom  he  passes  this  right,  or 
some  depositor  whose  cash  is  withdrawn  to  redeem  the 
check,  may  be  regarded  as  a  lender.  One  person  after 
another  holds,  for  a  time,  the  right  to  draw  money  from 

1  See  §  4  of  this  chapter  (II  of  Part  I). 


32     THE  EXCHANGE  MECHANISM  OF  COMMERCE 

a  bank,  and  delays  using  that  right.  In  the  aggregate, 
there  is  a  very  great  deal  of  such  delaying  or  waiting  on 
the  part  of  persons  who  are  entitled  to  money  whenever 
they  desire  it,  but  who  do  not  find  it  convenient  to  claim 
it  at  once.  Each  of  them  knows  that  he  can  collect  from 
a  bank,  at  will,  or  can  pass  his  claim  to  another,  at  will, 
for  any  desired  goods.  Yet  commonly  there  is  an  interval 
during  which  such  a  person  remains  a  creditor  or  lender, 
preferring  the  convenience  of  an  available  bank  account 
to  the  immediate  possession  of  other  goods.  Commercial 
banking  has  as  a  function  to  combine  and  coordinate 
such  sporadic  potential  lending  or  sporadic  waiting,  so  as 
to  put  at  the  disposal  of  borrowers  a  sum  total  of  actual 
lending  which  is  fairly  constant  in  amount.  If  A  leaves 
his  claim  on  a  bank  untouched  for  one  week,  B  for  two 
weeks,  and  C  for  a  week  and  a  half,  because  convenience 
so  dictates,  why  may  not  D,  in  the  meanwhile,  be  using 
the  capital  which  they  do  not  yet  wish  to  use?  By 
bringing  all  these  parties  together,  commercial  banking 
enables  D  to  get  the  use  of  capital  without  at  all  incon- 
veniencing A,  B,  or  C.  Each  of  these  can  get  his  capital 
to  use  whenever  it  is  convenient,  but,  in  practice,  all  of 
them  will  not  want  it  at  the  same  time. 

It  may  be  objected  that  the  foregoing  treatment  is  too 
concrete  to  be  true.  In  any  individual  case  of  borrowing, 
it  is  perhaps  not  legitimate  to  pair  off  each  borrower  with 
one  or  more  ultimate  lenders,  assuming  that  a  particular 
holder  of  a  deposit  (or  two  or  three  such)  is  the  real  lender 
to  some  special  borrower.  Banks  bring  together  bor- 
rowers and  lenders  in  large  numbers,  and  there  is  no  log- 
ical way  to  assign  two  or  more  into  pairs  or  small  groups. 
But  it  cannot  be  denied  that  if  the  total  of  loans  is  taken, 
the  ultimate  lenders  are  the  total  number  of  acceptors  of 


THE  NATURE  OF  BANK  CREDIT  33 

checks  and  depositors  of  money,  both  of  which  classes  are 
depositors  in  the  broad  sense,  because  both  are  possessors 
of  the  right  to  draw.  Since  the  receivers  of  checks  are 
as  much  holders  of  rights  to  draw,  that  is,  of  deposits,  as 
are  the  cash  depositors,  we  may  say  that  all  the  borrowers 
are  in  debt  to  all  the  holders  of  deposits  and  that  the  latter 
are  lenders  to  the  former.  When  a  borrower  of  a  deposit 
has  not  transferred  it,  he  may  be  regarded  as  indebted 
to  himself,  since  his  right  to  draw  may  be  regarded  as  in 
the  main  backed  up  by  his  own  promise  to  pay.  The 
interrelations  of  banks  through  a  clearing  house  merely 
extend  these  relations  to  persons  depositing  in,  borrowing 
from,  and  receiving  checks  on,  other  banks.  The  prin- 
ciples are  the  same  as  in  the  case  of  a  single  bank. 

The  upshot  of  the  matter  is  that  modern  commercial 
banking  makes  it  possible  for  men  to  do  business  with 
each  other  by  becoming,  successively  and  alternately, 
through  the  banks  as  intermediaries,  each  other's  debtors 
and  creditors ;  while  yet  no  one  of  them  needs  to  remain 
a  creditor  or  lender  longer  than  suits  his  convenience. 

§4 

Why  Commercial  Banking  Commends  Itself  to  Business 
Men,  both  as  Lenders  and  Borrowers,  so  that  Com- 
mercial Bank  Credit  becomes  a  Substitute  for  Money 

Thus  bank  credit  acts  as  a  substitute  for  money.  Its 
use  is  simply  a  process  by  which  persons  become,  so  to 
speak,  successively  each  other's  creditors,  in  such  way  as 
ultimately  to  cancel  obligations  with  only  a  little  use  of 
cash.  But  we  have  yet  to  see,  fully,  just  why  bank 
credit  is  able  to  displace  money,  to  a  large  extent,  as  a 
medium  of  exchange.  It  does  this  by  conferring  an 


34    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

advantage  upon  both  borrowers  and  ultimate  lenders. 
Ultimate  lenders,  as  such,  are  benefited  by  the  conven- 
ience of  a  banking  service  for  which  they  do  not  have  to 
pay.  Borrowers  are  benefited  in  that  they  can  borrow 
on  better  terms  from  banks  than  would  otherwise  be 
possible. 

We  have  already  seen  that  commercial  banking  com- 
bines and  coordinates  waiting  which  would  in  any  case 
be  done.  Such  waiting  includes,  for  example,  the  wait- 
ing done  by  a  man  who  has  money  in  his  pocket  which  he 
intends  to  spend.  It  may  be  a  long  time  before  he  does 
spend  it,  but  he  knows  that  at  any  time  he  may  spend  it, 
and  when  it  is  convenient  he  will  do  so.  Practically 
everybody  finds  it  desirable  to  keep  part  of  his  assets 
in  ready  cash,  to  use  as  occasion  may  require.  The 
convenience  of  having  the  ready  cash  compensates  for 
the  loss  of  the  interest  that  might  be  received  from 
various  investments,  and  so  may  perhaps  be  regarded 
as,  itself,  a  kind  of  interest.  The  same  holds  true  of  bank 
deposits  subject  to  check  demand.  Business  firms  must 
keep  part  of  their  assets  in  such  form  as  to  be  able  to  meet 
current  expenses  and  occasional  emergencies.  They 
usually  keep  considerable  amounts  to  their  credit  in  some 
bank.  Even  in  the  absence  of  banks,  money  would 
have  to  be  kept  on  hand,  and  there  would  be  a  great  deal 
of  sporadic  waiting  remunerated  only  by  the  convenience 
of  having  cash  on  hand  when  wanted. 

The  lender,  therefore,  that  is,  for  example,  the  receiver 
of  a  check  on  a  bank,  who  becomes  a  depositor  and 
supplies  waiting,  is  not  injured  but  rather  is  benefited  by 
commercial  banking.  He  can  draw  upon  his  account  at 
will,  and  this  account  is  both  safer  and  more  convenient 
(especially  for  making  large  payments  and  payments  of 


THE  NATURE  OF  BANK  CREDIT     35 

odd  sums)  than  the  equivalent  of  ready  cash  would  be. 
There  are,  consequently,  many  persons  who  would  be  and 
are  lenders,  without  any  further  payment  of  interest  than 
the  deposit  service  of  banks.  The  lending  involves,  in 
each  case,  only  such  waiting  as  is  convenient  and  as 
would  be  done  anyway.  And  it  is  more  satisfactory  to 
have  the  bank  deposit,  thus  making  this  waiting  available 
as  lending,  than  to  keep  all  quick  assets  in  cash.  From 
the  side  of  the  ultimate  lenders,  there  is  no  difficulty  in 
seeing  how  bank  credit  may  be  substituted  for  money, 
to  a  large  extent,  with  advantageous  results.  It  should 
be  noted  that  the  ultimate  lenders  are,  by  making  their 
waiting  available  to  borrowers,  really  adding  to  the 
wealth-producing  efficiency  of  the  community.  Were 
it  not  for  this  bank  credit,  i.e.  this  combination  of 
sporadic  waiting,  borrowers  could  only  be  similarly 
provided  for  by  the  use  of  money.  But  a  quantity  of 
money  corresponding  to  such  possible  bank  credit,  sup- 
posing the  money  to  be  of  standard  money  metal,  e.g. 
gold,  would  be  a  tremendous  capital  investment  and 
would  involve,  therefore,  great  expense.  An  equivalent 
additional  investment  in  other  capital,  if  made  possible  by 
a  partial  substitution  of  safe  bank  credit  for  specie  money, 
is  more  profitable  to  the  community.  The  same  total 
amount  of  capital  is  thus  made  to  produce  larger  results. 
Let  us  now  consider  the  interests  of  the  borrowers. 
They  also  will  be  ready  to  encourage  the  system,  because 
it  enables  them  to  secure  loans  at  relatively  favorable 
rates.  The  banking  system  combines  and  coordinates, 
as  we  have  seen,  a  great  deal  of  waiting  which  would  be 
done  in  any  case.  This  it  puts  at  the  disposal  of  short- 
term  borrowers,  so  adding  to  the  supply  of  loans.  If 
borrowers  will  avail  themselves  of  these  loans,  which  will, 


36    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

obviously,  on  the  principles  already  set  forth,  take  chiefly 
the  form  of  bank  credit  rather  than  of  cash,  a  lower  rate 
of  interest  becomes  possible.  But  it  becomes  possible 
only  because  borrowers  are  making  use  of  waiting  which 
would  in  any  case  be  done,  only  because  such  use  enables 
society  to  get  along  with  less  of  other  currency,  pre- 
sumably with  less  of  gold,  and  so  enables  a  larger  amount 
of  society's  total  capital  to  be  held  in  other  forms.1 

These  conclusions  apply  no  less  when  the  formal  ar- 
rangement is  somewhat  different.  Not  infrequently 
A  buys  goods  for  which  he  gives  his  promissory  note  to 
B.  B  endorses  this  note  and  deposits  it  with  his  bank, 
and  thereby  secures  a  deposit  account.  The  bank  is 
under  obligation  to  honor  B's  checks  upon  it  for  the 
amount  for  which  A's  note  was  discounted.  But  A  is 
under  obligation  to  pay  the  bank.  Taking  a  large 
number  of  such  transactions,  we  may  say  that  all  the 
makers  of  notes  so  deposited,  along  with  other  debtors 
to  banks,  are  in  debt  to  all  the  holders  of  bank  deposits, 
and  that  the  latter  are  creditors  of  the  former.  Business 
takes  place  by  means  of  different  persons  assuming,  suc- 
cessively, the  position  of  creditors,  through  the  banks  as 
intermediaries,  to  such  persons  as  A.  The  fact  that  spo- 
radic waiting  is  brought  together,  undoubtedly  tends  to 
give  A's  personal  note  more  value,  i.e.  makes  the  interest 

1  The  same  principle  applies  to  government  paper  money,  as  was  shown  in 
Chapter  I  (of  Part  I),  §  6.  In  that  case,  the  government  is  the  borrower  and 
pays  no  interest.  So  far  as  bank  credit  makes  impossible  the  issue  of  so  much 
paper  money  by  government,  the  lower  interest  to  borrowers  from  banks  does 
not  involve  economy  in  the  use  of  gold  and  lower  average  interest.  For  then 
the  government  itself,  having  to  borrow  by  issuing  more  bonds  than  would, 
perhaps,  be  necessary  if  it  issued  credit  money,  must  pay  interest  which,  other- 
wise, it  would  not  have  to  pay.  This  conclusion  does  not  mean,  of  course,  that 
inelastic  government  paper  money  is  to  be  preferred  to  elastic  bank  credit; 
nor  does  it  mean  that  government  paper  money  is  to  be  preferred  to  bank  credit, 
on  other  accounts. 


THE  NATURE  OF  BANK  CREDIT      37 

he  has  to  pay  somewhat  lower.  The  bank  can  give  more 
for  the  note  than  it  otherwise  could,  just  because  its  own 
creditors  will  not  all  want  cash  at  once,  just  because  its 
lending  power  (for  the  bank  is  making  itself  a  creditor  of 
or  lender  to  A)  is  made  greater  by  the  existence  of  the 
sporadic  waiting  which  it  has  combined ;  and  since  the 
bank  can  give  more  for  the  note  to  B,  B  can  give  more 
for  it  (in  goods)  to  A. 

The  principle  is  the  same  if  B  deposits,  not  A's  promis- 
sory note,  but  a  bill  (or  draft)  on  A,  payable  in  some  30 
or  60  days,  for  goods  shipped  to  A.  This  draft  will  be 
presented  to  A  for  his  signature  as  soon  as  possible. 
That  is,  A  will  be  expected  to  acknowledge  his  in- 
debtedness by  "accepting"  the  draft.1  The  bill  (or 
draft)  thus  becomes,  in  effect,  A's  promissory  note 
indorsed  by  B. 

In  Europe,  particularly  in  England,  still  another 
method  of  securing  bank  credit  is  common.  This  is  the 
method  of  bank  acceptances.2  The  would-be  borrower, 
A,  instead  of  directly  borrowing  of  his  bank  a  checking 
account,  or  instead  of  giving  his  creditor,  B,  a  promissory 
note,  for  deposit,  if  desired,  in  B's  bank,  or  instead  of 
having  B  make  out  a  draft  directly  upon  him,  gets  some 
bank  to  agree  to  "accept"  (i.e.  become  responsible  for 
the  payment  of)  drafts  which  B  may  draw  upon  this 
bank  up  to  an  agreed  amount.  A  can  then  pay  to  B 
whatever  is  owing  to  the  latter,  by  arranging  to  have  B 
draw  a  draft  upon  the  bank  with  which  the  agreement  has 

1  For  fuller  discussion  of  such  "bills  of  exchange"  and  their  security,  see 
Ch.  Ill  (of  Part  I),  §  7. 

*  For  a  description  of  acceptances  and  a  study  of  their  effects,  see  Lawrence 
Merton  Jacobs,  "Bank  Acceptances,"  National  Monetary  Commission,  1910. 
See  further,  also  in  National  Monetary  Commission,  Paul  M.  Warburg,  "The 
Discount  System  in  Europe,"  pp.  7-13. 


38    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

been  made.  The  bank  in  question  will  undertake  to 
pay  the  draft  when  it  becomes  due,  say  in  60  days.  But 
the  agreement  is  that  before  it  does  become  due,  A  shall 
provide  the  bank  with  the  necessary  funds.  The  bank 
with  which  the  agreement  is  made,  guarantees  payment 
to  B,  but  does  not  expect  to  draw  upon  its  own  resources 
in  making  such  payment.  B  can  deposit  the  draft  with 
his  own  bank  for  credit.  B  then  has  a  right  to  draw 
from  his  own  bank  on  demand ;  his  bank  has  a  claim  upon 
the  bank  with  which  A  made  the  above  described  arrange- 
ment; and  this  bank  has  a  claim  upon  A.  B,  or  those 
receiving  from  him  checks  upon  his  bank,  may  be 
regarded  as  the  ultimate  creditor  or  creditors;  A  is 
obviously  the  ultimate  debtor.  The  banks  are  inter- 
mediaries. Also,  the  banks  have  brought  together  the 
waiting  of  those  who  successively,  for  periods  dictated 
by  their  own  convenience,  become  creditors  of  the  bank- 
ing system  by  receiving  checks  or  deposit  rights  based 
on  the  draft  for  which  A  is  ultimately  responsible. 
Further,  the  fact  that  this  sporadic  waiting  is  made 
available  as  actual  lending,  means  that  B's  draft  on  the 
bank  will  be  discounted  at  a  somewhat  lower  rate  than  it 
otherwise  probably  could  be,  and  will  therefore  bring  a 
better  price.  Since  the  draft  for  a  given  sum  has  thus 
a  somewhat  higher  value  to  B  than  it  would  else  have,  the 
latter  will  be  ready  to  charge  A  in  payment  for  any 
definite  amount  of  goods  sold,  a  somewhat  lower  price 
than  otherwise.  In  effect,  because  of  the  waiting  made 
available  by  the  banking  system,  A  borrows  at  a  lower 
rate  of  interest.  The  same  principle  is  involved  if,  as 
frequently  happens,  A  himself  draws  a  draft  upon  a 
bank  which  agrees  to  "accept"  it,  and  sells  it  to  another 
bank  for  credit.  Those  who  receive  A's  checks  on  this 


THE  NATURE  OF  BANK  CREDIT  39 

credit,  in  payment  for  goods,  are  then  the  ultimate 
lenders  in  the  sense  above  explained. 

Whatever  the  formal  arrangement  by  which  bank 
credit  is  utilized,  the  charges  to  the  borrowers  or  debtors 
(for,  in  the  last  analysis,  it  is  always  the  borrowers  or 
debtors  who  pay)  must  be  enough  to  cover  the  cost  of 
banking  service.  These  charges  must  remunerate  the 
banks  for  concentrating  waiting  where  it  has  the  greatest 
usefulness.  They  must  cover  salaries  of  bank  officials, 
depreciation  of  bank  property,  interest  on  the  capital 
invested  by  the  banks  themselves,  and  compensation  for 
the  risk  to  the  banks,  of  insolvency,  for  the  banks,  though 
chiefly  go-betweens  or  intermediaries,  do  nevertheless 
insure  the  credit  of  borrowers.  If  all  the  borrowers 
failed  to  make  good,  the  banks  must  fail;  but  within 
limits  the  banks  can  and  do  guarantee  depositors.  This 
they  do,  largely,  by  maintaining  cash  reserves  of  per- 
haps TV  to  J  of  their  deposits,  according  to  conditions 
and  the  requirements  of  law,  from  which  they  can  liqui- 
date as  many  of  their  demand  obligations  as  are  likely 
to  be  suddenly  presented  for  payment  at  any  one  time. 
On  these  reserves,  as  on  their  other  capital,  the  banks 
expect  to  realize  a  reasonable  interest. 

In  other  words,  the  payments  made  by  borrowers  must 
cover  the  cost  of  banking  plus  a  fair  return  on  banking 
capital.  These  payments  would  not  do  this  if  the 
demand  for  loans  from  banks  were  very  small,  and  if 
such  demand  could  be  sufficiently  met  by  the  funds  of 
depositors  who  would  be  willing  to  pay  the  cost  of 
banking,  for  the  sake  of  the  convenience  of  banking 
service.  The  demand  for  bank  loans,  however,  is  far 
in  excess  of  what  could  be  supplied  by  means  so  trivial, 
and  is,  indeed,  sufficient  to  throw  upon  borrowers  or 


40     THE  EXCHANGE  MECHANISM  OF,  COMMERCE 

debtors  as  such,  the  whole  cost  of  banking  service. 
When  those  who,  through  the  intermediation  of  banks, 
are  the  ultimate  lenders  or  creditors,  have  become  such 
by  having  the  promissory  notes  of  or  drafts  on  their 
debtors  discounted,  the  creditors  may  seem  to  be  paying 
the  cost  of  banking.  But,  in  such  cases,  they  have,  pre- 
sumably, made  allowances  for  the  bank  rate  of  discount, 
in  the  prices  they  have  charged  for  goods  sold,  and  the 
debtors,  therefore,  really  pay  for  the  services  of  the 
banks. 

The  payments  by  borrowers  or  debtors  may  be  re- 
garded, then,  as  real  interest  payments  in  the  sense  that 
the  ultimate  lenders  profit  by  the  existence  of  a  place  of 
deposit  other  than  their  own  vaults,  for  which  they  do 
not  have  to  pay,  and  profit  further  by  the  facility  of 
check  payments  thus  made  practicable.  If  no  money 
interest  is  received  by  the  ultimate  lenders,  the  amounts 
paid  by  borrowers  are,  in  the  long  run,  because  of  the 
competition  of  different  banks,  determined  by  the  labor 
cost  of  rendering  the  service,  plus  the  interest  (including 
compensation  for  risk)  on  the  cost  value  of  the  machinery, 
such  as  buildings,  necessary  reserves,  etc.,  used  in  bring- 
ing borrowers  and  real  lenders  together.  If,  however, 
there  is  not  a  sufficiency  of  this  "convenience  waiting" 
to  be  had  to  supply  the  demand  for  loans  at  the  mere 
cost  of  concentration,  then  the  banks  will  bid  against 
each  other,  not  so  much  to  cut  down  the  charge  for  the 
service  performed  for  borrowers,  as  to  get  deposits. 
Hence  we  are  beginning  to  see  direct  interest,  though  at 
low  rates,  very  generally  offered  on  deposits  subject  to 
check,  either  on  monthly  balances  or  otherwise. 


THE  NATURE  OF  BANK  CREDIT     41 

§S 

Application  of  Principles  Arrived  at,  to  Bank  Notes 

The  same  principles  apply  to  bank  notes  as  to  bank 
deposits.  The  bank  note,  when  issued  on  the  sole 
responsibility  of  a  bank,  is,  like  the  deposit,  a  credit 
obligation  of  the  bank  to  the  holder.  The  holder  is 
entitled  to  specie  or  other  legal  tender  money  on  demand. 
As  with  deposits,  these  rights  to  draw  circulate  from 
hand  to  hand  in  payment  for  goods.  And  as  with 
deposits,  the  real  lender  or  creditor  is  the  person  who 
receives  the  bank  notes,  which  represent  only  a  claim 
in  payment  for  goods  sold ;  while  the  ultimate  debtor 
is  the  person  —  or  the  persons  —  who  has  borrowed  the 
bank's  credit  in  this  form,  either  directly  or  by  any  of  the 
methods  just  described  in  relation  to  deposits,  and  is 
under  obligation  to  repay.  The  bank  is  a  legally  re- 
sponsible intermediary,  but  is  chiefly  dependent,  in  the 
long  run,  for  means  to  redeem,  on  repayment  of  loans  by 
its  debtors.  The  bank,  in  the  main,  is  merely  an  inter- 
mediary, although,  as  with  deposits,  part  of  its  own  cap- 
ital serves  as  an  insurance  fund  to  cover  all  contingencies 
which  are  reasonably  likely  to  occur. 

But  the  holders  of  bank  notes  are  frequently  given,  by 
government,  greater  protection  against  loss  than  the 
holders  of  deposits.  In  Canada,  for  example,  the  note- 
issuing  banks  have  to  contribute  to  a  special  reserve  fund 
to  redeem  the  notes  of  failed  banks,  besides  which  note 
holders  have  a  prior  lien.  In  the  United  States,  note 
holders  are  insured  against  loss  by  the  Federal  govern- 
ment, which  makes  itself  ultimately  responsible  for  all 
notes  issued  in  conformity  with  the  national  banking 
law,  and,  therefore,  for  all  bank  notes  issued,  since  a 


42    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

10  per  cent  tax  on  other  bank  notes  effectually  keeps  them 
out  of  circulation.  The  notes  issued  by  national  banks 
are  based  chiefly 1  on  government  bonds.  Each  national 
bank  must  have  purchased  bonds  of  the  United  States, 
the  par  value  and  also  the  market  value  of  which  shall 
be  at  least  equal  to  all  its  notes  in  circulation.  These 
bonds  must  have  been  deposited  with  the  Comptroller 
of  the  Currency.  The  banks  must  also  have  deposited 
in  cash  a  redemption  fund  of  5  per  cent  of  the  face  value 
of  their  notes.  In  consideration  of  these  safeguards, 
the  United  States  assumes  ultimate  responsibility  for 
the  redemption  of  the  bank  notes  in  case  of  the  failure 
of  any  bank,  and,  in  fact,  undertakes  to  redeem  the  notes 
currently  for  those  persons  presenting  them,  out  of  the 
5  per  cent  redemption  fund.  These  bond-secured  bank 
notes  will,  however,  be  gradually  withdrawn  over  a  period 
of  years.  The  recent  Federal  Reserve  Act  permits  their 
gradual  retirement  and,  in  addition,  the  2  per  cent  gov- 
ernment bonds,  on  which  alone  they  can  be  based,  will, 
as  they  mature,  be  permanently  withdrawn.  The  recent 
Federal  Reserve  Act,  however,  creates  from  eight  to  twelve 2 
Federal  reserve  banks  through  which  Federal  reserve 
notes  shall  be  issued.  Back  of  these  the  Federal  reserve 
banks  must  keep  a  40  per  cent  gold  reserve,  of  which 
not  less  than  J,  or  5  per  cent,  shall  be  in  the  Treasury  of 
the  United  States.  These  notes  are  to  be,  in  each  case, 
a  first  lien  upon  the  assets  of  the  bank  through  which 
they  are  issued.  But  the  government  makes  itself 
ultimately  responsible  for  their  redemption.  The  notes 

1  The  provisions  of  the  Aldrich-Vreeland  emergency  currency  measure  will 
shortly  be  superseded  by  those  of  the  Federal  Reserve  Act  of  1913.  The  Aldrich- 
Vreeland  Act  cannot  be  availed  of  after  July  i,  1915.  The  new  law  is  already 
(August  1914)  being  put  into  operation. 

1  Made  twelve  by  the  Organization  Board. 


THE  NATURE  OF  BANK  CREDIT  43 

are  issued  to  the  Federal  reserve  banks  for  them  to  lend 
out,  at  the  discretion  of  the  Federal  Reserve  Board,  a 
government  regulating  body.  They  partake  in  part  of 
the  character  of  government  paper  money  and  in  part 
of  the  character  of  bank  notes.  It  is  customary  in 
European  countries  also,  to  safeguard  especially  bank 
notes  as  contrasted  with  deposits.  The  holder  of  a 
deposit  is  supposed  to  become  a  depositor  only  delib- 
erately and  after  consideration  of  the  financial  soundness 
of  his  chosen  bank.  But  bank  notes  circulate  from  hand 
to  hand  as  "money,"  are  received  often  in  the  form  of 
wages  by  the  comparatively  poor,  and  are  not  usually 
scrutinized  to  see  from  what  bank  they  come;  nor  is 
the  soundness  of  the  bank  usually  considered. 

§6 

iv'e  Statement  of  the  Relation  of  Money,  together^ 
with  Bank  Credit,  to  Prices  f 

The  foregoing  explanation  of  the  nature  of  commercial 
banking  operations  makes  clear,  it  is  hoped,  that  these 
operations  economize  the  use  of  money  and  why  they  do 
economize  such  use.  The  rights  to  draw  from  banks, 
thus  circulating  in  place  of  government  or  "lawful" 
money  (whether  these  rights  are  evidenced  by  checks 
or  by  bank  notes)  we  may  call  Mf,  and  the  average 
velocity1  with  which  they  circulate,  V.  Then  our 
equation  becomes 2 

MV  +  M'V  =  pq  +  p'q'  +  etc.3 

1  Estimated  by  Fisher,  Purchasing  Power  of  Money,  p.  285,  as  averaging,  in 
recent  years,  towards  50. 

2  Stated  in  Ch.  I  (of  Part  I),  §  i,  without  the  inclusion  of  bank  credit. 

8  The  equation  of  exchange  has  been  so  stated  as  to  include  credit,  by  Kern- 
merer,  Money  and  Credit  Instruments  in  their  Relation  to  General  Prices,  New 
York  (Holt),  1907,  p.  75  J  and  by  Fisher,  The  Purchasing  Power  of  Money, 
P.  48. 


44    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

The  general  level  of  prices  is  somewhat  higher  and  the 
value  of  money  is  somewhat  lower,  because  of  the  addi- 
tional use  of  credit.  The  conditions  of  supply  and 
demand  require  a  somewhat  higher  level  of  prices,  just 
as  we  have  seen  that  they  do  when  there  is  more  money. 
Gold  is  cheaper.  The  demand  for  it  is  less.  It  does  not 
need  to  be  produced,  and  cannot  profitably  be  produced, 
at  such  a  low  margin,  i.e.  from  such  unfavorable  sources 
of  supply,  as  would  otherwise  be  worth  while.  But 
this  bank  credit  is  not  altogether  an  addition  to  currency ; 
it  decreases  the  amount  of  gold  money,  and  so  is  largely 
a  substitution  of  a  cheaper  for  a  dearer  currency. 

But  if  bank  credit  can  thus  take  the  place  of  money,  is 
there  any  limit  to  such  substitution?  Why  might  not 
credit  expand  and  prices  rise,  or  money  be  pushed  out, 
indefinitely?  The  answer  is  that  the  amount  of  bank 
credit  is  pretty  definitely  related  to  the  amount  of  money. 
In  the  first  place,  a  certain  amount  of  cash  is  needed  in  the 
banks,  to  maintain  confidence.  The  amount  so  needed 
bears  a  relation  to  the  amount  of  bank  credit,  and  must 
be  some  reasonable  per  cent  of  such  credit.  Otherwise, 
the  public  is  likely  to  become  frightened  and  demand  cash, 
and  this  cash  cannot  be  paid.  A  margin  against  such 
contingencies  is  always  essential  and,  for  national  banks 
of  the  United  States  and  Federal  reserve  banks,  as  well 
as  frequently  for  State  banks,  is  required  by  law.  Ref- 
erence has  just  been  made 1  to  this  requirement  in  the  case 
of  the  Federal  reserve  notes.  So  the  total  bank  credit 
is  related  to  the  total  bank  reserves  or  cash  in  the  banks.2 
Banks  maintain  the  proper  relation  between  deposits 
and  reserves,  by  adjusting  their  rates  of  interest  (or  dis- 

1  §  5  of  this  chapter  (II  of  Part  I). 

2  White,  Money  and  Banking,  third  edition,  Boston  (Ginn),  1008,  p.  197. 


THE  NATURE  OF  BANK  CREDIT  45 

count)  charged  to  borrowers.  If  the  deposits  are  in 
danger  of  becoming  too  great,  relative  to  the  reserves,  a 
higher  charge  to  borrowers  will  discourage  borrowing,  and 
so  will  limit  the  increase  of  those  deposits  which  originate 
in  the  borrowing  of  deposit  rights  (or  in  the  discounting 
of  notes  and  acceptances). 

The  total  bank  credit  is  related,  also,  to  the  total  cash 
in  circulation.1  Bank  deposits  passed  by  means  of  checks 
are  absolutely  unavailable  for  very  many  transactions. 
They  are  unavailable  when  the  maker  of  a  check  is 
unknown,  and  they  are  unavailable,  practically,  for  small 
payments,  such  as  street  car  fares.  Even  bank  notes 
cannot  fill  up  the  entire  circulation  when,  as  is  usually 
the  case,  the  government  allows  them  to  be  issued  only 
in  relatively  large  denominations.  The  smaller  denomi- 
nations are  needed  and  government  money  is  used. 
Business  convenience,  then,  also  compels  a  relationship 
between  the  quantity  of  bank  credit  and  the  quantity  of 
government  money. 

Since  the  quantity  of  bank  credit  is  related  in  these 
two  ways  to  the  quantity  of  government  coined  and 
government  issued  money,  changes  in  the  latter  tend  to 
bring  proportionate  changes  in  the  former.  It  is  still 
true  that  prices  depend  upon  the  quantity  of  money, 
though  the  dependence  is  in  part  indirect.  The  demand 
for  goods  comes  from  those  who  have  bank  credit  to 
offer  as  well  as  from  those  who  have  only  money.  And  we 
may  now  speak,  not  merely  of  the  supply  of  money  and 
the  demand  for  it,  but  of  the  supply  of  currency  (includ- 
ing both  money  and  circulating  credit),  and  the  demand 
for  it. 

1  Fisher,  The  Purchasing  Power  of  Money,  p.  50. 


46    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

§7 

Fluctuations  of  Bank  Credit 

But  though  the  amount  of  bank  credit  is  thus  related 
to  the  amount  of  money,  the  ratio  between  them  is 
slightly  rhythmic  rather  than  definitely  constant. 
During  periods  of  hope  and  confidence,  bank  credit 
tends  to  expand,  and  prices  to  rise.  During  periods  of 
distrust  and  depression,  the  volume  of  circulating  credit 
tends  to  be  smaller,  and  prices  to  be  lower.  When 
prosperity  is  generally  expected,  business  men  are 
anxious  to  extend  their  credit  by  borrowing  of  the  banks 
for  the  purchase  of  merchandise  and  for  other  business 
purposes.  The  banks  can  then  increase  their  deposits 
by  making  loans,  as  much  as  their  available  reserves  will 
permit.  When,  for  any  reason,  doubt  and  fear  prevail, 
even  low  discount  rates  may  not  induce  an  equal  amount 
of  borrowing. 

The  sharpest  changes  in  the  relation  of  the  quantity  of 
circulating  bank  credit  to  the  quantity  of  money  come  as 
the  consequence  of  panic.  So  far  as  a  panic  is  foreseen, 
the  banks  endeavor  to  prepare  themselves  for  it  by 
decreasing  their  demand  liabilities  in  relation  to  their  cash 
on  hand  or  reserves.  That  is,  they  cut  down  their  loans 
by  raising  their  rates  of  discount.  As  the  panic  spreads, 
the  necessity  of  such  a  policy  becomes  evident  to  nearly 
all  the  banks.  Any  bank  may  suddenly  find  itself  sub- 
jected to  the  danger  of  a  run  upon  it,  and  dares  not 
increase  the  danger  by  making  extensive  loans.  Those 
banks  upon  which  there  actually  are  runs,  find  themselves 
with  depleted  reserves,  and  are  peculiarly  unable  to 
extend  credit.  The  bank  rate  of  discount,  then,  rises 


THE  NATURE  OF  BANK  CREDIT     47 

rapidly,  while  the  volume  of  bank  credit,  M ',  decreases, 
and  prices  fall. 

At  such  a  time  of  stress,  a  great  national  bank  (or  a 
few  great  banks)  which  keeps  large  reserves  beyond  the 
requirements  of  ordinary  years,  is  a  tower  of  strength, 
and  can  usually  prevent  any  general  collapse  of  credit. 
Such  an  institution  is  the  Bank  of  England,  which  holds 
itself  responsible  for  the  credit  structure  of  the  nation, 
and  maintains  always  an  emergency  reserve.  In  the 
United  States,  the  recent  Federal  Reserve  Act  (of  1913) 
directs  the  establishment  of  not  less  than  eight  or  more 
than  twelve 1  Federal  reserve  banks.  All  national  banks, 
and  all  other  banks  which  become  members  of  the 
system,2  are  required  to  keep  a  portion  of  their  reserves 
in  one  of  the  Federal  reserve  banks.  The  aim  is  to  have  a 
large  part  of  the  nation's  banking  reserve  concentrated 
in  these  few  large  banks  so  that  ample  means  may  be 
available  in  time  of  panic  for  the  aid  of  any  sound  bank 
which  finds  itself  threatened  by  the  unreasoning  fear  of 
depositors.  The  Federal  reserve  banks  are  themselves 
required  to  keep  each  a  35  per  cent  reserve  in  lawful 
money  against  deposits  and  a  40  per  cent  reserve  in  gold 
against  the  Federal  reserve  notes  which  they  have  out- 
standing. This  requirement  insures  the  maintenance 
in  ordinary  times  of  a  reserve  which  may  be  needed 
in  case  of  a  financial  crisis.  But  when  there  is  financial 
crisis  or  the  fear  of  it  and  many  banks  are  curtailing 
their  loans,  one  of  the  things  most  needed  is  the  assurance 
that  credit  can  be  secured  by  those  whose  assets  are  good 
and  whose  business  is  dependent  upon  credit.  At  such 
a  time  new  reservoirs  of  credit  may  need  to  be  opened 

1  Made  twelve  by  the  Organization  Board. 

2  With  a  temporary  exception  stated  in  the  act. 


48    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

until  the  old  ones,  temporarily  closed,  are  again  un- 
locked. The  new  law  therefore  provides  that  the 
Federal  Reserve  Board,  the  government  regulating 
body,  may  temporarily  suspend  any  of  the  reserve  re- 
quirements, but  only  by  levying  a  proportional  tax  on 
the  banks  so  favored. 

But  while  it  is  desirable  that  the  violent  credit  fluc- 
tuations associated  with  crises  should  be  avoided,  some 
seasonal  rise  and  fall  of  bank  credit  is  desirable.  In 
agricultural  countries,  particularly,  the  amount  of  trade 
immediately  after  the  crop  season  is  greater  than  at  other 
times,  and  an  alternate  expansion  and  contraction  of 
bank  credit,  corresponding  to  the  expansion  and  contrac- 
tion of  business,  tends  to  keep  prices  more  stable  rather 
than  to  make  them  less  so.  In  the  United  States,  the 
circulation  of  the  Federal  reserve  notes  provided  for  in 
the  new  currency  bill,  and  the  gradual  retiring  of  the  old 
bond-secured  bank  notes,  will  tend  to  an  elasticity  of  bank 
credit  in  the  form  of  notes,  comparable  to,  though  perhaps 
less  than,  the  elasticity  of  deposits.  The  new  law  requires 
that  no  Federal  reserve  notes  originally  issued  by  one 
Federal  reserve  bank  shall  be  paid  out  by  another  such 
bank  but  shall  be  sent  promptly  for  credit  or  redemption 
to  the  issuing  bank.  The  effect  of  this  provision  must 
be  to  give  at  least  some  slight  elasticity  to  the  volume  of 
these  notes.  For  the  notes  will  be  lent  out  as  business 
conditions  favor,  and  will  pass  into  circulation.  They 
will  then  be  used  by  borrowers,  along  with  other  means 
of  payment,  to  liquidate  debts  to  the  various  banks,  will 
flow  in  considerable  volume  to  the  Federal  reserve  banks, 
and  must  then  be  cancelled  against  other  debts  or  re- 
deemed. Bank  deposits  in  the  United  States  are  nor- 
mally elastic,  and  will  doubtless  continue  to  be  so.  The 


THE  NATURE  OF  BANK  CREDIT      49 

banks  lend  perhaps  nearly  all  their  reserves  will  support, 
at  certain  times,  and  at  other  times  accumulate  reserves 
in  preparation  for  the  season  or  seasons  of  largest  lending. 

§8 
Summary 

Let  us  now  bring  together,  in  brief  compass,  the  main 
conclusions  of  this  chapter.  We  saw,  to  begin  with,  that 
credit  does  not  really  act  as  a  substitute  for  money  unless  \ 
there  is  the  possibility  of  cancellation,  unless  the  same  j 
credit  (though  not  necessarily  the  same  paper  evidence 
of  it)  circulates  more  than  once.  It  usually  does  this 
in  the  case  of  the  bank  deposit  or  right  to  draw  from  a 
bank.  This  right  to  draw,  circulating  by  check  or  draft, 
is  a  substitute  in  trade  for  legal  tender  money,  tends 
somewhat  to  increase  the  total  supply  of  currency,  and 
tends  to  drive  out  other  currency. 

Analysis  of  the  relations  of  the  various  parties  con- 
cerned, to  each  other,  showed  that,  apart  from  their 
function  of  insuring  the  credit  of  borrowers  by  risking 
some  capital  of  their  own,  banks  are  really  but  inter- 
mediaries between  those  who  borrow  of  them,  and  the 
real  lenders.  These  lenders  are  the  depositors,  since  it  is 
the  depositors  who  have  given  up  present  goods  by  de- 
positing, in  the  banks,  money  which  they  might  have 
spent,  by  accepting  checks  in  return  for  goods  sold, 
or  by  receiving  the  promissory  notes  of  or  drawing  drafts 
on  the  purchasers  of  the  goods,  and  having  such  notes 
or  drafts  discounted  by  banks.  If  the  borrowers  as  a 
whole  were  unable  to  repay,  then  the  banks  would  be 
unable  to  pay  the  depositors  what  the  latter  were  entitled 
to.  What  the  banks  do  is  to  bring  together  borrowers 


50    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

and  lenders,  making  available  to  borrowers,  in  the  form 
of  loans,  sporadic  waiting  which  would  in  any  case  exist. 
Through  the  institution  of  commercial  banking,  trade  is 
carried  on  by  means  of  people  becoming  successively 
and  alternately  each  other's  creditors.  The  demand  for 
loans  from  borrowers  is  sufficient  to  throw  upon  them  the 
cost  of  maintaining  the  banking  system.  Nevertheless, 
the  existence  of  that  system^by  making  possible  the 
bringing  together^  sporadic  waiting,  tends  to  make  the 
interest  charge  to  borrowers  lower  than  it  would  probably 
otherwise  be.  Bank  notes  involve  the  same  principles 
as  bank  deposits,  though  the  holders  of  bank  notes  are 
commonly  protected  or  insured  to  a  greater  degree  by 
government  than  depositors. 

Bank  credit  is  related  to  the  quantity  of  money  by  the 
habits  and  business  requirements  of  the  community  and 
by  the  necessity  of  a  sufficient  reserve.  But  the  relation 
between  bank  credit  and  money  is  rhythmic  rather  than 
exactly  constant.  %  The  fluctuations  seem  to  be,  in  large 
part,  closely  connected  with  the  alternation  of  business 
confidence  and  business  distrust,  and  with  the  occurrence 
of  panics.  The  banking  system  should  be  so  well 
organized  and  conservatively  managed  as  to  minimize 
such  fluctuations  of  credit.  On  the  other  hand,  a  certain 
degree  of  elasticity  in  bank  currency,  making  it  expand 
and  contract  according  to  the  seasonal  variations  of  trade, 
appears  to  be  desirable. 


CHAPTER  III 

THE  NATURE  AND  METHOD  or  FOREIGN  EXCHANGE 


The  Function  of  Bills  of  Exchange 

IN  the  last  chapter  we  saw  that  in  the  most  3|ghly 
civilized    countries,    particularly    the    English-spe 
countries,  the  largest  part  of  trade  is  carried  on  by 
of  bank  credit.     This  form  of  credit,  circulating  by  me 
of  checks,  is,  in  the  United  States,  of  almost  unive: 
use  as  to  all  large  scale  dealings  within  a  city  or  other 
circumscribed  area. 

We  saw,  also,  that  the  use  of  this  bank  credit,  through 
checks  or  bank  notes,  is  merely  a  means  by  which  bor- 
rowers and  lenders  are  brought  together,  the  bank 
being  but  an  intermediary ;  that  it  is  a  means  by  which 
one  person  or  firm  can  become,  in  the  sense  explained  in 
the  preceding  chapter,  a  debtor  successively  to  a  second, 
third,  fourth,  fifth,  etc.,  so  that  money  has  only  to  pass 
from  the  first  through  the  bank  or  through  two  or  more 
banks  and  a  clearing  house,  to  the  last.  All  the  inter- 
mediate transactions  may  then  cancel,  or  cancellation 
may  at  times  be  complete,  so  that  no  balance  remains. 
Cancellation  of  these  serial  and  opposing  debts  thus  be- 
comes our  principal  means  of  carrying  on  modern  busi- 
ness. And  trade  is  still,  in  the  last  analysis,  as  in  primi- 
tive barter  or  as  where  money  is  the  medium,  an  exchange 
of  goods  for  other  goods.  We  buy  goods  and  become,  in 

51 


52    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

effect,  debtors.  We  sell  goods  and  become  creditors. 
The  debts  cancel  and  we  have  traded  goods  for  goods. 

Bills  of  exchange  enable  us  to  extend  this  system  of 
credit  beyond  the  town  or  city,  beyond  the  state,  beyond 
the  nation.  Business  firms  separated  hundreds  of  miles 
from  each  other  can  become  debtors  and  creditors  of  one 
another  through  the  intermediation  of  the  banking  and 
exchange  system.  The  credit  structure  becomes  inter- 
national. Through  the  commercial  and  the  exchange 
banks,  a  New  York  firm  can  become,  in  effect,  suc- 
cessively the  debtor  of  a  London  firm,  another  London 
firm,  a  Glasgow  firm,  a  Berlin  firm,  a  Boston  firm,  and 
another  New  York  firm.  That  is,  these  different  business 
houses  successively  become  claimants  of  the  banking 
system,  through  their  receipts  of  checks  or  drafts  from 
one  another,  or  through  their  drawing  bills  of  exchange 
on  one  another,  or  both,  of  the  sum,  or  part  of  it,  originally 
borrowed  from  a  New  York  bank,  as  a  deposit,  by  the 
first  mentioned  New  York  firm.  In  trade  between 
nations,  or  between  widely  separated  parts  of  the  same 
nation,  credit  is  used,  debts  in  large  part  cancel,  and 
money  is  used  to  a  relatively  small  degree. 

Bills  of  exchange  or  drafts  serve  in  large  part,  then,  the 
same  purposes  as  ordinary  checks.  Over  long  distances, 
however,  whether  business  crosses  national  boun- 
daries or  not,  the  "customer's  check"  is  not  likely  to  be 
satisfactory.  The  receiver  may  have  hard  work  to  cash 
it  or  to  get  for  it  an  immediate  addition  to  his  bank 
balance.  In  the  distant  locality  to  which  the  check  is 
sent,  nobody,  probably,  knows  the  maker  well,  or  knows 
whether  the  maker's  check  is  good.  In  this  regard,  the 
bank  draft  is  superior.  Or  the  creditor  may  not  wish 
to  wait  for  what  is  owed  to  him,  until  a  check  arrives 


METHOD  OF  FOREIGN  EXCHANGE  53 

from  his  debtor.     In  this  regard,  a  commercial  draft  is 
superior. 

Foreign  and  domestic  exchange  are  in  principle  the 
same.  The  former  involves  payments  between  persons 
in  different  countries,  countries  which  have,  generally, 
different  currencies  and  which  are  often  separated  from 
each  other  by  natural  barriers.  Domestic  exchange  in- 
volves dealing  between  different  parts  of  the  same  coun- 
try, but  parts  too  far  from  each  other  for  the  ordinary, 
convenient  use  of  checks. 

§2 

The  Nature  of  Bills  of  Exchange 

Let  us  now  inquire  what  is  the  nature  of  the  bill  of 
exchange.  Suppose,  to  take  the  simplest  possible  case, 
that  B  owes  to  A  the  sum  of  $1000,  and  that  A  owes  a  like 
sum  to  C.  The  form  of  settlement  will  be  that  of  the 
bill  of  exchange  if  A  orders  B  to  pay  C.  When  B  complies 
with  the  order,  his  debt  to  A  and  A's  debt  to  C  are  both 
liquidated.  Usually  the  bill  of  exchange  involves  an 
exchange  banker  or  broker  as  one  of  the  parties.  But 
in  any  case  it  is  always  of  the  form  :  A  orders  B  to  pay  C. 

The  reader  may  at  once  note  that  in  so  far  the  bill  of 
exchange  resembles  the  ordinary  check,  which  is,  in  fact, 
but  one  species  of  bill  of  exchange.  But  a  distinction  can 
be  made,  based  partly  upon  the  relation  of  a  bank  or 
banks  to  others  concerned.  In  the  case  of  the  "  custom- 
er's check,"  A,  the  drawer,  is  a  mercantile  or  industrial 
establishment  or  a  person,  while  B,  the  drawee,  is  always 
a  bank.  In  the  case  of  the  commercial  draft,  A  and  B 
are  usually  persons,  or  commercial  or  industrial  establish- 
ments (except  that,  as  with  the  "bank  acceptances"  de- 


54    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

scribed  in  the  previous  chapter,1  B's  bank  may  be  desig- 
nated by  him  as  the  drawee  in  his  place),  while  C,  the 
payee,  is  usually,  though  not  necessarily,  a  bank.  In 
the  case  of  the  bank  draft,  both  A,  the  drawer,  and  B, 
the  drawee,  are  banks.  The  payee  may  be  a  person  or 
an  ordinary  business  firm.  Furthermore,  a  check  is 
always  a  demand  claim  (a  demand  draft  of  one  bank  on 
another  is  frequently  called  a  "check")?  while  a  draft 
may  or  may  not  be.  We  shall  have  occasion  to  notice, 
later  on,  the  significance  of  some  of  these  different  re- 
lations. What  we  have  here  to  emphasize  is  that  the 
bill  of  exchange  or  draft  and  the  ordinary  check  are 
exactly  alike  in  involving  three  parties,  of  whom  one 
orders  a  second  to  pay  a  third ;  and  that  the  distinction 
rests,  in  part,  upon  the  position  which  the  bank  or  banks 
concerned,  if  any,  occupy  in  relation  to  the  other  persons 
or  person. 

§3 

How  Bills  of  Exchange  Might  be  Used  to  Settle  Obligations, 
Assuming  no  Banks 

If  credit  is  to  serve  appreciably  as  a  medium  of  ex- 
change or  substitute  for  money,  then  when  credit  is  given 
there  must  generally  be  three  parties.  When  there  are 
but  two  persons  concerned,  the  giving  of  credit  is  usually 
only  a  postponement  of  payment.  There  is  not  an 
avoidance  of  the  use  of  money,  except  in  those  com- 
paratively rare  cases  where  B's  debts  to  A  now  are 
balanced,  or  partly  balanced,  by  later  obligations  incurred 
by  A  to  B.  Then,  of  course,  credit  may  lead  to  cancella- 
tion. If  three  or  more  persons  are  concerned,  in  addition 
to  banks  or  other  intermediaries  (and  even  if  banks  are 

i§4ofCh.II(PartI). 


METHOD  OF  FOREIGN  EXCHANGE  55 

included  in  the  three,  this  would  be  true  in  form),  can- 
cellation always  takes  place. 

But  we  have  yet  to  see  just  how  bills  of  exchange  or 
drafts  are  used  to  balance  obligations  in  foreign  trade. 
To  begin  with,  we  shall  take,  as  being  the  simplest,  a  case 
seldom  realized  in  practice,  namely,  where  four  parties 
can  settle  up  their  various  debts  without  resort  to  any 
bank,  exchange  broker,  or  other  go-between.  Suppose 
that  an  American  merchant,  whom  we  shall  designate 
as  AI,  owes  to  an  English  manufacturer,  EI,  the  sum  of 
£100  ($486.65),  while  the  latter  owes  as  much  to  an 
English  merchant,  E2,  who  in  turn  owes  an  equal  sum  to 
an  American  manufacturer,  A2.  We  may  represent 
the  situation,  graphically,  as  follows : 


owes 


•U~i 

t 


owes 


t 


">  i 

Obviously,  if  the  parties  all  know  each  other  and  know 
of  the  situation,  they  can  very  easily  settle  all  three 
debts  with  but  one  use  of  money.  EI  may  make  out  a 
bill  on  AI  ordering  him  to  pay  E2.  Thus  EI  cancels 
his  debt  to  E2.  E2  may  then  indorse  the  bill,  making 
it  payable  to  A2,  thus  liquidating  his  (E2's)  debt  to  A2. 
Finally,  A2  presents  the  bill  to  AI,  who  cancels  his  debt 


56    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

to  EI  by  paying  it.  Thus,  three  debts  have  been  paid 
with  but  one  use  of  money.  Suppose  that,  in  addition 
to  the  other  debts,  A2  owes  $486.65  to  AI.  Then  our 
diagram  would  be : 


owe$ 


I  t 

owes  owes 


owes 


A2  might  then  pay  by  indorsing  the  bill  to  AI,  who  would, 
therefore,  have  only  to  pay  himself.  In  that  case,  four 
debts  would  be  settled  with  no  use  of  money  at  all. 

§4 

Settlement  of  Obligations  by  Drafts  (Bills  of  Exchange), 
through  Intermediation  of  Banks,  Assuming  Creditors 
to  Draw  Drafts  on  Debtors 

Our  illustration,  however,  must  be  modified  if  it  is  to 
picture  the  usual  commercial  practice.  The  different 
parties  having  occasion  to  use  or  to  pay  drafts  or  bills  of 
exchange  cannot  be  expected,  ordinarily,  to  know  each 
other.  They  must  therefore  deal  with  middlemen,  with 
the  so-called  exchange  bankers  or  exchange  brokers. 
When  foreign  exchange  is  carried  on  through  the  inter- 
mediation of  bankers  or  exchange  brokers,  each  bill  of 
exchange  is  still  of  the  form,  A  orders  B  to  pay  C.  But 


METHOD  OF  FOREIGN  EXCHANGE  57 

an  exchange  banker  is  now  in  the  position  of  both  A 
and  B,  or  of  C. 

There  are  several  ways  by  which  debts  can  be  settled 
through  the  use  of  the  exchange  banking  machinery. 
One  way  is  for  the  creditor  to  draw  upon  the  debtor, 
ordering  him  to  pay  a  bank.  Another  is  for  the  debtor 
to  remit  to  the  creditor  by  sending  the  latter  a  bank 
draft.  Let  us  take  up,  first,  cases  where  the  creditor 
draws  on  the  debtor.  We  will  suppose  the  same  four 
persons,  AI,  A2,  EI  and  E2,  but  will  now  assume  what 
is  the  usual,  if  not  indeed  the  universal,  fact,  that  they 
deal  with  each  other  through  middlemen.  These  middle- 
men may  be  two  banking  houses  dealing  in  foreign 
exchange,  one,  Ba,  an  American  bank,  and  the  other,  Be, 
an  English  bank.  We  shall  suppose,  as  before,  that  AI 
owes  EI,  EI  owes  E2,  E2  owes  A2,  and  A2  owes  AI.  All 
that  is  needed  for  cancellation  is  that  the  parties  be 
brought  together.  Diagrammatically  this  situation  is: 


Owes- 


owes- 


EI  makes  out  a  draft  on  A!  ordering  AI  to  pay  Be.  EI 
may  be  said  to  sell  this  draft  to  Be.  Ei's  bank,  Be,  may 
then  give  EI  the  money,  but  will  more  probably  (since 
EI  is  likely  to  prefer  it)  put  the  amount  to  his  credit  as 


58    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

a  depositor.  Be  sends  this  draft,  directly  or  indirectly, 
to  Ba  for  collection.  Ba  will  subtract  it  from  the  credit 
account  of  its  customer,  AI.  So  far,  no  money  has  been 
used.  Ei  has  an  addition  to  his  deposit  account.  AI 
has  suffered  a  subtraction  from  his.  EI  has  the  claim 
on  the  banks  which  AI  has  lost.  EI  may  now  settle 
his  obligation  to  £2  by  a  check  on  Be.  E2  then  realizes 
an  addition  to  his  deposit  account  with  Be,  while  EI 
suffers  a  diminution  of  his  bank  account.  Next,  A2  may 
make  out  a  draft  on  his  debtor,  E2  (or,  as  where  E2  has 
arranged  for  " acceptances,"  directly  on  E2's  bank), 
ordering  E2  (or  his  bank  for  him)  to  pay  Ba.  Ba  may  send 
this  draft  to  Be  for  collection.  A2  now  has  an  addition 
to  his  deposit  account  in  Ba.  E2's  bank  account  is 
decreased.  Lastly,  A2  settles  with  AI  by  check  on  Ba. 
AI  has  now  an  addition  to  his  bank  account  which  may 
cancel  the  original  subtraction,  while  A2  suffers  a  sub- 
traction which  may  be  equal  to  the  previous  addition. 
Four  debts  may  have  been  cancelled,  with  no  use  of 
money.  In  any  case,  there  has  been  less  use  of  money 
because  of  the  use  of  drafts,  for  the  banks  concerned  com- 
pare accounts,  and  only  net  balances  have  to  be  paid  in 
money  or  in  gold.  The  use  of  bills  of  exchange  extends 
to  trade  between  nations,  and  equally  to  trade  between 
widely  separated  parts  of  the  same  nation,  the  operation 
of  the  bank  credit  system. 

Even  if  we  suppose  that  Ba  (for  example),  the  exchange 
bank  which  collects  the  draft  on  AI,  is  not  the  bank  in 
which  AI  regularly  keeps  a  deposit  account,  nevertheless 
the  rule  that  trade  is  carried  on  by  a  cancellation  of 
credits,  still  holds.  Though  Ba,  upon  receiving  from  Be 
the  draft  drawn  by  EI  upon  AI,  cannot  then  directly 
subtract  the  amount  from  AI'S  account,  it  can  call  on  AI 


METHOD  OF  FOREIGN  EXCHANGE  59 

for  payment.  Either  the  draft  will  be  made  payable 
to  AI'S  bank  and  by  that  bank  subtracted  from  his  deposit 
there,  or  it  will  be  presented  directly  to  AI  himself,  in 
which  case  he  will  probably  pay  it  by  giving  Ba  a  check 
on  his  own  bank.  In  any  case,  then,  EI'S  bank  account 
will  probably  be  increased  and  AI'S  bank  account  de- 
creased by  virtue  of  the  draft. 

On  the  other  hand,  A2's  bank  account  will  be  increased 
when  he  sells  his  draft  on  E2,  though  he  sells  this  draft 
to  an  exchange  dealer  not  engaged  in  a  regular  banking 
business.  For  such  an  exchange  dealer  will  presumably 
pay  him  for  his  draft  by  means  of  a  check  upon  some 
bank,  which  he  can  then  deposit  for  credit  in  his  own 
bank.  His  deposit  account  is  increased  and  E2's  is 
decreased  by  the  transaction.  In  any  case,  Ba,  or  some 
other  exchange  bank,  has  to  pay  A2,  directly  or  indirectly, 
and  receives  payment,  directly  or  indirectly,  from  AI; 
in  any  case,  Ba  collects  one  draft  for  Be  and  sends  one 
draft  to  Be  for  collection.  In  any  case,  there  is  cancella- 
tion, and  the  shipment  of  gold  is  wholly  or  partially 
avoided.  A2  may  pay  AI  by  check  as  above  suggested, 
or,  if  they  are  widely  separated,  AI  may  draw  a  domestic 
draft  on  A2  and  deposit  the  draft  in  his  bank  for  credit. 
The  draft  will  go  to  A2's  bank  or  to  A2  for  collection  and 
A2's  bank  account  will  be  decreased. 

Attending  only  to  the  international  relations  involved, 
we  may  say  that  A2's  draft  on  E2  constitutes  part  of  the 
supply,  in  the  United  States,  of  bills  on  England.  The 
desire  of  an  American  bank,  e.g.  Ba,  to  purchase  this  bill, 
signifies  a  demand,  in  the  United  States,  for  bills  on  Eng- 
land. This  demand  may  be  said,  in  the  last  analysis, 
to  result,  partly,  from  the  necessity  which  some  American 
bank  (or  banks)  is  under,  of  remitting  to  an  English 


60    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

bank  or  banks,  after  collecting  for  the  latter;  and  so 
may  be  said  to  result,  to  some  extent,  from  the  supply, 
in  England,  of  commercial  drafts  on  Americans.  We 
may  assert,  therefore,  that  the  supply  of  such  commercial 
bills  on  America,  in  the  English  market,  corresponds,  in 
part,  to  demand  for  bills  on  England,  in  the  American 
market,  and,  in  part,  gives  rise  to  this  demand.  The 
basic  principle  is  of  course  similar  in  the  relations  between 
different  parts  of  the  same  country.  In  general,  supply 
in  one  place,  of  commercial  bills  on  another,  gives  rise  to 
demand  in  the  other,  for  bills  on  the  first. 

To  avoid  misunderstanding,  it  should  be  pointed  out 
that  foreign  exchange,  in  the  complications  of  practical 
business,  is  often  three  cornered,  four  cornered,  etc., 
involving  merchants  and  banks  of  several  countries. 
Thus,  Americans  may  have  purchased  goods  of  English 
merchants ;  the  latter  may  have  bought  goods  in  Ger- 
many ;  and  Germans  may  have  imported  goods  from  the 
United  States.  Supposing  the  creditors  in  each  case 
to  draw  upon  their  debtors,1  there  would  be  sold  in  Eng- 
land, drafts  on  merchants  in  the  United  States; 
in  Germany,  drafts  on  English  purchasers;  and  in 
the  United  States,  drafts  on  Germans.  The  drafts 
in  England,  on  Americans,  would  be  sent  to  American 
banks  for  collection.  The  American  banks  must  then 
settle  with  their  English  correspondents.  This  would 
create  a  demand  for  drafts  on  foreign  countries,  but 
might  not  directly  create  a  demand  for  drafts  on 
England.  For  the  American  banks  might  purchase 
drafts  on  Germany  and  send  these  in  settlement  to  their 
correspondents  in  England.  These  drafts  would  be 
collectible  through  German  banks,  which  might  settle 

i  See,  however,  §  5  of  this  chapter  an  of  Part  I). 


METHOD  OF  FOREIGN  EXCHANGE  61 

by  purchasing,  and  sending  to  their  English  correspond- 
ents, the  drafts  on  England  drawn  by  German  exporters. 
In  practice,  then,  the  supply  in  England  of  drafts  on  the 
United  States  may  not  directly  give  rise  to  a  demand  in 
the  United  States  for  drafts  on  England.  Instead,  it 
may  lead  to  a  demand  in  the  United  States  for  drafts  on 
Germany,  and  to  a  demand  in  Germany  for  drafts  on 
England.  These  complications  should  not  be  over- 
looked, but,  since  they  introduce  no  new  principle,  they 
may,  for  simplicity,  be  ignored  in  most  of  our  study. 

§5 

Settlement  of  Obligations  by  Bank  Drafts,  when  Debtors 
Remit  to  Creditors 

Obligations  between  persons  in  widely  separated  places 
may  also  be  cancelled  through  the  use  of  bank  drafts. 
Instead  of  creditors  drawing  on  their  debtors,  the  debtors 
then  remit  to  their  creditors.  What  method  shall  be 
adopted  in  each  case  will  depend  upon  the  understanding 
between  the  parties  concerned  as  creditor  and  debtor. 
If  AI  owes  EI  and  is  to  pay  by  means  of  a  bank  draft, 
he  may  go  to  the  bank,  Ba,  and  request  such  a  draft 
payable  to  EI.  This  he  will  pay  for  out  of  his  deposit 
with  Ba,  or  by  a  check  on  whatever  bank  he  has  an 
account  with,  or  (conceivably  but  rarely)  with  money. 
The  draft  AI  gets  is  really  a  kind  of  check  made  out  by 
one  bank  on  another.  Ba  makes  out  an  order  upon  Be 
(or  some  other  English  bank)  requiring  payment  to  EI. 
This  order  is  handed  by  the  American  bank  to  AI,  who 
sends  it  to  EI,  and  the  last  named  person  is  then  in  a 
position  to  present  the  draft  for  cash  or,  more  probably, 
credit,  to  Be  or  to  his  regular  deposit  bank.  E2  may  simi- 


62    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

larly  settle  with  A2  by  getting  a  draft  from  Be  ordering 
Ba  to  pay  A2.  We  may  suppose  EI  to  settle  with  E2  and 
AZ  with  AI  by  check,  as  before.  Or  we  may  suppose  that 
they  are  separated  from  each  other  by  considerable  dis- 
tances and  likewise  settle  with  each  other  by  using  bank 
drafts.  The  matter  of  form  is  unessential.  In  any  case, 
most  obligations,  both  international  and  intranational, 
can  be  settled  by  cancellation,  through  the  banks. 

Where  settlement  is  made  by  the  use  of  bank  drafts, 
there  must,  of  course,  be  some  arrangement  between  the 
banks  concerned,  such  as  deposit  accounts  kept  by  each 
with  the  other,  so  that  all  of  these  drafts  will  be  honored 
without  question.  There  is  no  need  of  any  special 
arrangement  in  the  case  of  checks,  since  these  can  be  sent 
at  once,  and  with  no  appreciable  loss  of  time  in  transit, 
through  a  clearing  house,  to  the  bank  on  which  they  are 
drawn.  But  with  bank  drafts,  used  where  the  distances 
are  greater,  the  situation  is  otherwise. 

Where  bank  drafts  are  used,  these  constitute  part  of 
the  supply  of  drafts,  and  the  demand  for  them  is  a  demand 
by  persons  and  by  business  houses,  who  have  remittances 
to  make,  as  well  as  by  banks.  Thus,  a  part  of  the  supply, 
in  the  United  States,  of  bills  on  England  is  made  up  of 
the  drafts  of  American  upon  English  banks ;  and  a  part 
of  the  demand,  in  the  United  States,  for  bills  on  England 
is  the  demand  for  bank  drafts,  by  business  houses  having 
obligations  to  meet  in  England  and  desiring  to  meet 
them  in  that  way. 

Third,  cancellation  may  take  place  by  the  use  of  both 
of  these  methods,  i.e.  by  both  drawing  and  remitting. 
For  instance,  A2  makes  out  a  bill  on  E2  ordering  the  latter 
to  pay  Ba.  Ba  sends  it  to  Befor  collection  (or  discount) . 
Ba  thus  gets  a  claim  upon  or  a  credit  with  Be.  AI  desires 


METHOD  OF  FOREIGN  EXCHANGE  63 

to  remit  a  bank  draft  to  EI.  He  seeks  of  Ba,  such  a  draft. 
Ba,  having  purchased  A2Js  draft  on  £2  and  secured  a 
credit  balance  in  England,  is  able  to  sell  AI  a  draft  on  Be 
payable  to  EI. 

This  is  the  way  in  which,  as  a  matter  of  practice,  most 
of  our  transactions  with  England  are  settled.  When 
Englishmen  owe  us,  we  usually  draw  drafts  upon  them  or 
their  banks,  i.e.  we  draw  upon  London.  We  do  not,  as 
a  rule,  arrange  for  them  to  remit  drafts  on  New  York. 
On  the  other  hand,  if  we  owe  them,  the  understanding 
commonly  is  that  we  shall  purchase  drafts  on  London  and 
remit.  American  banks,  then,  buy  drafts  on  London 
from  those  Americans  having  English  debtors,  send  these 
drafts  to  their  London  correspondents,  and,  on  the 
balances  in  London  so  secured,  sell  drafts  on  their 
London  correspondents  to  Americans  having  English 
creditors.  The  opposite  operations  are  indeed  carried  on, 
but  they  are  much  less  common.  In  general,  it  may  be 
said  that  other  countries  draw  drafts  on  England  in 
much  larger  volume  than  England  draws  upon  them.1 

Three-cornered  exchange,  also,  may  involve  chiefly 
bills  on  London.  Thus,  if  Americans  have  exported  cot- 
ton to  England  and  imported  mechanical  instruments 
from  Germany,  while  Germany  has  purchased  cloth  of 
England,  drafts  on  London  may  be  used  in  part  for  all 
three  settlements.  American  exporters  of  cotton  will 
draw  drafts  on  the  English  purchasers.  These  drafts 
may  be  used,  in  part,  by  American  banks,  for  remittances 
to  Germany,  as  a  basis  for  the  sale  of  bank  drafts  to 
American  importers  who  must  remit  to  Germany. 
German  banks  will,  in  turn,  send  these  drafts  on  the 

1  Clare,  The  A. B.C.  of  the  Foreign  Exchanges,  London  (Macmillan),  1893, 
p.  12. 


64    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

English  importers  of  cotton  to  England,  in  order  to 
maintain  balances  there  for  the  sale  of  drafts  to  remit- 
ting German  importers  of  cloth. 

London  is,  in  fact,  the  world's  greatest  financial  centre. 
Partly,  perhaps,  because  banking  is  most  fully  developed 
in  England,  partly  because  of  the  magnitude  of  England's 
foreign  trade  and  the  fact  that  payments  have  to  be  made 
to  English  exporters  by  merchants  of  all  other  countries, 
drafts  on  London  are  nearly  everywhere  in  demand. 
Sellers  of  goods,  in  most  parts  of  the  world,  usually  prefer 
to  take  advantage  of  this  fact  and  realize  on  their  sales 
at  once.  On  the  other  hand,  English  exporters  more 
usually,  though  not  always,  wait  for  remittances  from 
foreign  purchasers  of  their  goods.  The  loss  of  time 
necessarily  incident  to  exchange  transactions  falls,  then, 
except  as  it  is  allowed  for  in  higher  prices  of  goods  sold, 
more  largely  on  English  manufacturers  and  merchants 
and  less  largely  on  other  countries. 

Coming  back  to  the  consideration  of  trade  between 
England  and  the  United  States,  we  may  conclude  that 
drafts  drawn  by  American  business  houses  on  English 
business  houses  (or  upon  banks  properly  designated  by 
the  latter),  and  drafts  drawn  by  American  banks  upon 
English  banks,  are  both  part  of  the  supply,  in  the  United 
States,  of  bills  on  England.  The  demand  for  such 
bills  has  also  a  twofold  source.  It  comes,  first,  from 
those  persons  and  firms  other  than  banks,  who  have  obli- 
gations to  meet  in  England  which  they  wish  to  meet  by 
remitting  bank  drafts.  Second,  the  demand  comes  from 
banks  which  may  desire  bills  of  exchange  on  England 
for  either  or  both  of  two  purposes :  in  order  to  maintain 
accounts  in  England,  against  which  they  may  sell  bank 
drafts;  and,  though  less  frequently,  in  order  to  remit 


METHOD  OF  FOREIGN  EXCHANGE  65 

funds  to  English  banks  which  are  sending  to  them,  for 
collection  and  settlement,  drafts  on  American  business 
men.  As  there  is,  in  the  United  States,  both  supply  of 
and  demand  for  exchange  on  England,  so  there  is,  in 
England,  both  supply  of  and  demand  for  exchange  on  the 
United  States.  The  case  is  similar  in  our  commercial 
relations  with  other  countries,  and  in  the  relations  of 
different  parts  of  the  United  States  itself,  to  each  other. 

§6 

How  Exchange  Banks  Make  Profits 

A  market  may  be  defined  as  the  coming  together  of 
buyers  and  sellers.  It  therefore  involves  all  the  mecha- 
nism necessary  to  facilitate  their  intercourse.  One  may 
speak  of  a  general  market  or  of  a  local  market,  of  a  market 
in  one  or  in  another  place.  Thus,  there  is  the  New  York 
market  for  the  buying  and  selling  of  exchange  on  London. 
A  bank  in  New  Haven,  Conn.,  may  be  a  part  of  that  mar- 
ket if  it  buys  from  and  sells  to  it.  That  market  includes, 
besides  the  commercial  and  industrial  organizations 
which  buy  or  sell  drafts,  all  middlemen  of  whatever  class 
who  engage  in  the  trade. 

The  middlemen  may  be  divided  roughly  into  three 
classes.1  First  may  be  mentioned  banks  which  do  a  reg- 
ular foreign  exchange  business,  buying  bills  from  those 
who  have  them  to  sell  and  selling  their  own  drafts  on 
foreign  correspondents  to  persons  desiring  to  remit. 
Much  of  this  business  is  done  by  foreign  exchange  banks 
which  carry  on  little  or  no  other  business.  Some  of  it 
is  done  by  ordinary  commercial  banks,  such  as  United 

1  Cf .  Escher,  Elements  of  Foreign  Exchange,  New  York  (The  Bankers  Publish- 
ing Company),  191 1,  p.  60. 
F 


66    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

States  National  banks,  in  addition  to  their  other  banking 
business.  Second,  we  may  call  attention  to  those  ex- 
change dealers  whose  principal  business  is  to  buy  com- 
mercial and  bankers'  bills,  and  to  resell  them,  chiefly 
to  banks.  Third  are  the  independent  brokers  who  make 
small  commissions  by  bringing  buyers  and  sellers  to- 
gether. These  do  not  invest  their  own  capital,  do  not, 
that  is,  buy  bills  of  exchange  in  the  market,  but  assist 
those  desiring  to  sell  bills  to  find  buyers,  and  vice  versa. 

The  bankers  and  brokers  engaged  in  the  business  of 
foreign  exchange  make  their  money  from  commissions 
and  by  the  difference  between  what  they  pay  for  exchange 
and  what  they  get  for  it.  Thus,  when  a  bank  sells  its 
own  drafts  drawn  upon  a  correspondent  bank,  it  will 
probably  expect  to  receive  a  better  price  than  it  is  willing 
to  pay  for  the  commercial  drafts  it  buys  and  remits.  Its 
credit  is  probably  better  than  the  credit  of  most  mer- 
cantile and  industrial  establishments,  and  its  drafts, 
therefore,  more  to  be  desired.  And  it  will  hardly  care  to 
engage  in  the  business  without  receiving  some  profit  as 
a  reward  or  payment  for  its  services. 

It  might  be  supposed  that  business  men,  e.g.  in  the 
United  States,  desiring  to  remit  to  foreign  creditors, 
would  sometimes  buy,  through  the  intermediation  of 
exchange  brokers,  the  identical  bills  drawn  by  other 
American  merchants  on  their  foreign  debtors,  instead 
of  remitting  by  means  of  bank  drafts.  This,  however, 
while  perfectly  possible,  is  seldom  done  in  practice. 
Perhaps  one  reason  is  that  the  business  man  desiring  to 
remit  has  much  more  confidence  in  the  credit  of  a  bank 
than  in  the  credit  of  any  other  company,  and  hence 
prefers  to  buy  a  claim  on  a  bank  to  use  in  remitting. 
Another  and  a  very  practical  reason  is  that  an  exchange 


METHOD  OF  FOREIGN  EXCHANGE  67 

bank  can  give  a  draft  enabling  the  debtor  to  pay  the 
exact  sum  owed.  Were  he  to  buy  merchants'  bills,  it 
would  be  difficult,  if  not  impossible,  to  make  out  an  even 
sum,  since  they  would  be  for  various  amounts  dependent 
on  the  requirements  of  previous  transactions.  It  falls, 
therefore,  to  the  lot  of  the  banks  to  buy  up  bills  of 
exchange  or  drafts  of  various  amounts,  and  sell  their  own 
drafts,  in  such  sums  as  are  desired,  against  the  credit 
they  thus  obtain  abroad. 

§7 
Various  Types  of  Drafts 

Bills  of  exchange  run  for  various  lengths  of  time  before 
payment.  Some  of  them  are  sight  drafts,  payable  on 
presentation.  Others,  3o-day  bills  and  "long  bills," 
such  as  6o-day  and  go-day  bills,  are  payable  only  after 
the  lapse  of  a  definite  period  following  presentation  to  the 
drawee.  Bills  of  exchange,  furthermore,  may  be  drawn 
upon  and  by  persons  of  various  degrees  of  credit.  The 
credit  of  both  drawer  and  drawee  is  important,  since,  as 
in  the  case  of  checks,  if  the  drawee  fails  to  honor  a  bill,  the 
drawer  or  maker  of  the  bill  is  liable  to  the  payee.  Both 
of  these  considerations,  therefore,  namely  the  length 
of  time  a  bill  is  to  run,  and  the  credit  of  the  drawer  and 
drawee,  affect  the  bill's  value. 

Bills  of  exchange  may  be  either  "clean"  bills  or  docu- 
mentary.1 Clean  bills  are  those  which  have  no  attached 
documents  giving  security,  but  depend  for  their  value 
and  salability  solely  on  the  reputations  of  the  drawee 
(who  must  pay  the  bill)  and  the  drawer  (who  is  respon- 
sible to  the  holder  if  the  drawee  fails  to  pay).  A  bank 

1  Escher,  Elements  of  Foreign  Exchange,  pp.  45-52. 


68    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

draft  is  an  example  of  a  clean  bill.  Frequently  a  mer- 
chant's draft  on  another  merchant  is  a  clean  bill,  but 
this  is  not  so  universally  the  case. 

Very  usually  a  merchant's  or  manufacturer's  draft 
is  documentary,  i.e.  has  documents  attached.  Suppose 
A2  ships  £1000  worth  of  merchandise  to  E2.  He  may 
then  draw  a  bill  on  E2  ordering  the  latter  to  pay  £1000 
to  Ba.  Before  doing  this,  however,  or  at  any  rate  before 
disposing  of  the  draft,  A2  will  get  from  the  transportation 
company  by  which  the  goods  are  shipped,  a  bill  of  lading 
for  the  goods.  He  will  also,  probably,  insure  the  goods 
against  shipwreck  or  other  loss  or  damage  in  transit. 
The  bill  of  lading  certifies  the  claim  of  A2,  the  shipper, 
upon  the  transportation  company,  to  have  the  goods 
delivered  to  the  consignee.  The  consignee  eventually 
secures  the  goods  by  presenting  the  bill  of  lading  to  the 
transportation  company.  Likewise,  the  certificate  of  in- 
surance certifies  A2's  claim  upon  an  insurance  company, 
in  case  of  damage  or  loss.  A2,  having  made  out  the  draft 
on  E2,  will  attach  to  this  draft  the  bill  of  lading  and  the 
insurance  certificate,  before  disposing  of  it  to  any  bank. 
Possession  of  these  documents  is  then  some  protection  to 
the  bank  in  case  payment  is  refused.  If  neither  the 
drawee  nor  the  maker  of  the  draft  will  or  can  reimburse 
the  bank,  the  goods  may  be  sold,  because  usually  hy- 
pothecated, and  the  proceeds  applied  to  that  purpose. 

A  banker,  however,  is  not,  supposedly,  an  expert  in  the 
business  of  selling  the  goods  in  question,  and  may  not 
be  able  to  realize  the  best  price  for  them  without  going 
to  considerable  expense.  Also,  the  market  may  not 
remain  steady  and  the  goods  may  not  for  that  reason 
sell  for  enough  to  cover  the  bank's  advance.  The  busi- 
ness reputation  and  the  financial  standing  of  the  maker 


METHOD  OF  FOREIGN  EXCHANGE  69 

and  of  the  drawee  are  therefore  almost  always  of  impor- 
tance in  determining  the  value  of  a  draft.  If  their  credit 
is  not  established,  the  maker  or  drawer  cannot  hope  to 
receive  quite  as  large  an  amount  for  his  bill  as  otherwise 
he  might. 

Documentary  commercial  drafts,  other  than  sight 
drafts,  may  be  "acceptance  bills"  or  they  may  be  "pay- 
ment bills."  Acceptance  is  a  formal  acknowledgment 
of  obligation  by  the  drawee.  When  a  draft  is  presented 
to  him  for  acceptance,  he  writes  the  word  "accepted" 
and  his  signature,  across  its  face.  Where,  as  in  England, 
"bank  acceptances"  are  commonly  used,  a  merchant's 
bank  may  undertake  to  "accept"  drafts  for  him  and  so 
becomes  the  drawee.  When  an  acceptance  bill  is  drawn, 
the  drawee  has  sufficiently  good  credit  so  that  his 
acceptance  of  the  draft  gives  him  possession  of  the  bill 
of  lading  and  therefore  of  the  merchandise ;  though  the 
draft  may  be  for  90  or  120  days  after  sight,  during  which 
length  of  time  the  drawee  is  not  called  upon  for  payment. 
In  the  case  of  the  payment  bill,  the  drawee's  credit  is 
less  good.  Though  acknowledgment  in  the  form  of 
acceptance  will  be  asked  for,  he  cannot  obtain  the 
merchandise  consigned  to  him  by  merely  accepting  the 
bill  of  exchange,  but  must  actually  pay  it.1  If,  however, 
a  3o-day,  9O-day  or  other  payment  bill  is  paid  by  the 
drawee  before  maturity,  he  is  allowed  a  rebate  or  dis- 
count from  the  face  of  the  bill. 

In  the  case  of  perishable  goods,  e.g.  produce,  payment 
cannot  be  allowed  by  the  purchaser  to  run,  lest  the  prod- 
uce spoil.  He  pays  the  draft  at  once,  therefore,  under 

1  Escher,  Elements  of  Foreign  Exchange,  p.  40.  When  documentary  drafts 
are  made  payable  a  very  few  days  after  sight,  the  documents  are  apt  to  be  de- 
livered only  upon  payment.  Ibid.,  p.  52. 


70    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

the  rebate  of  interest  arrangement.1  But  this  rebate  will 
be  less  than  the  market  rate  of  discount  on  the  draft.  For 
it  is  not  to  be  expected  that  an  exchange  banker  should 
pay  a  high  price  for  a  draft,  only  to  receive  from  the 
drawee  less  than  he  paid  the  maker.  The  banker  is 
likely  to  safeguard  himself  against  such  a  contingency  by 
paying  for  the  draft  as  little  as  the  least  he  can  expect 
to  receive.  Looking  at  the  matter  from  another  point 
of  view,  we  may  say  that  the  allowance  made  for  payment 
before  maturity  is  not  likely  to  be  so  large  as  seriously 
to  affect  the  value  of  the  draft  to  the  maker  or  seller. 

Documentary  payment  bills  sent  to  England  by  Amer- 
ican banks  for  collection  cannot,  in  general,  be  discounted. 
The  principal  reason  for  this  is  that  such  a  bill  is  payable 
at  the  option  of  the  drawee  on  any  date  prior  to  maturity. 
If  the  goods  are  not  perishable  and  the  drawee  does  not 
immediately  require  them,  they  may  be  warehoused 
until  he  desires  them.  When  this  time  comes,  he 
obtains  the  bill  of  lading  by  making  payment  on  the 
draft.  It  is  convenient,  therefore,  that  the  draft  should 
remain,  until  payment,  with  the  banker  who  originally 
presented  it  for  acceptance,  in  order  that  the  drawee  may 
know  where  payment  should  be  made,  when  he  desires 
to  acquire  possession  of  the  merchandise.2  On  the  other 
hand,  acceptance  bills  drawn  on  English  merchants  or 
English  banks  are  usually  sold  at  a  discount  in  the  Lon- 
don discount  market  by  order  of  the  American  bank 
which  remits  them. 

^scher,  Elements  of  Foreign  Exchange,  p.  49. 

*Margraff,  International  Exchange,  Chicago  (Fergus  Printing  Co.),  1903, 
p.  115.  German  banks  themselves  discount  payment  bills  remitted  to  them, 
though  at  a  rate  of  discount  higher  than  the  market  rate,  while  English  banks 
do  not.  See  Margraff,  p.  135. 


METHOD  OF  FOREIGN  EXCHANGE  71 

§8 

The  Sale  of  Demand  Drafts  against  Remittances  of  Long 

Bills 

After  what  has  been  said  regarding  the  discount  of 
bills  of  exchange,  the  reader  will  easily  see  how  banks  can 
sell  their  own  demand  drafts  against  remittances  of  so- 
called  long  bills,  i.e.  bills  of  60  days,  90  days,  etc.  An 
American  bank,  Ba,  can  find  out  by  cable  at  what  rate 
bills  "to  arrive"  in  London  on  a  certain  date  or  by  a 
certain  steamer  will  be  discounted.  Ba  thereupon  buys 
the  bills  here  of  persons  having  debtors  abroad,  or  of 
other  bankers  or  exchange  dealers.  It  sends  these  bills 
to  its  London  correspondent,  say  Be,  with  orders  for 
immediate  discount,  i.e.  sale.  The  sum  realized  con- 
stitutes a  balance  abroad  to  the  credit  of  the  American 
bank,  a  balance  upon  which  it  then  sells  its  own  demand 
drafts  *  to  Americans  wishing  to  make  remittances.  A 
demand  draft  is  sometimes  sent  by  telegraph  and  is 
then  called  a  "  cable."  2  It  should  be  noted  that  Ba  has 
a  balance  abroad  long  before  the  bills  sent  abroad  by  it 
for  credit  have  matured,  since  these  bills  it  has  ordered 
sold  in  the  London  discount  market,  and  they  have  got 
into  the  possession  of  persons  or  houses  which  buy  such 
bills  as  investments.  In  the  United  States  there  is  no 
such  discount  market.  Drafts  made  out  in  England  on 
American  debtors,  after  being  purchased  by  English 
banks,  are  forwarded  to  American  correspondent  banks 
for  collection,  but  are  generally  held,  after  "acceptance," 
for  account  of  the  forwarding  English  banks,  until 
maturity,  instead  of  being  sold. 

1  Escher,  Elements  of  Foreign  Exchange,  p.  79. 

2  Ibid.,  p.  71. 


72    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

It  follows  that,  as  a  rule,  the  real  creditor  of  an  English 
firm  on  which  an  American  has  drawn  a  6o-day  or  go-day 
draft  is  not  the  American,  for  he  has  had  the  draft  dis- 
counted and  has  received  cash  or  credit.  Nor  is  it  the 
American  bank,  which  has  had  the  draft  sold  in  the 
London  market  and  received  a  credit  balance  with  its 
correspondent  or  has  thereby  liquidated  a  debt.  It  is 
rather  the  purchaser  of  that  draft,  in  London,  who  must 
wait  (unless  he  resells  it)  60  or  90  days  until  it  matures 
and  he  can  collect  from  the  debtor  firm  in  England. 
Or  we  may  go  one  step  farther  back  and  assert  that  the 
ultimate  creditors  are  depositors  (holders  of  rights  to 
draw)  in  that  English  bank  which  buys  the  draft  in 
question,  or  from  which  the  buyer  of  the  draft  borrowed 
the  means  to  buy  it.1  On  the  other  hand,  when  a  draft 
is  made  out  by  an  English  firm  on  an  American,  payable 
say  60  days  after  sight,  the  English  bank  which  dis- 
counts it  is  the  creditor,  and,  therefore,  ultimately,  its 
depositors  are  the  creditors.  For  the  draft  will  not 
usually  be  purchased  by  an  American  investor,  but  will 
be  held  by  the  correspondent  bank,  for  account  of  the 
English  bank,  until  maturity.  The  original  English 
debtor  has  received  payment,  but  for  the  time  being 
this  payment  has  come  from  other  English  capital  which 
will  only  be  reimbursed  when  the  American  firm  pays. 

As  a  matter  of  usual  practice,  however,  long  drafts  are 
not  drawn  upon  American  debtors.  The  absence  of  a 
discount  (or,  more  properly,  a  rediscount)  market  here 
means  that  importers  have  one  less  avenue  of  credit  open 
to  them.  Were  there  such  a  market,  drafts  drawn  upon 

1  "The  enormous  amount  of  bills  held  by  the  discount  companies  and  bill 
brokers  in  England  is  to  a  very  large  extent  carried  by  them  through  loans  on 
call  from  the  banks."  Paul  M.  Warburg,  The  Discount  System  in  Europe,  Na- 
tional Monetary  Commission,  1910,  p.  18. 


METHOD  OF  FOREIGN  EXCHANGE  73 

them  could  be  rediscounted  and  held  until  maturity  by 
whatever  bank  or  person  offered  the  best  rate.  Such  a 
bank  (and,  therefore,  ultimately,  its  depositors)  or  person 
would  be  the  real  source  of  credit.  It  is  not  easy  to  say 
just  why  we  have  not,  in  the  United  States,  a  rediscount 
market.  Custom  and  prejudice  may  be  largely  to  blame. 
In  general,  bankers  in  the  United  States  have  regarded 
it  as  evidence  of  financial  weakness  for  a  bank  to  attempt 
to  rediscount  the  notes  of  its  customers.  Furthermore, 
the  national  banking  law,  as  interpreted  by  the  courts,  has 
made  it  illegal  for  any  national  bank  to  "accept,"  for 
account  of  its  customers,  drafts  upon  it.1  In  England, 
banks  continually  accommodate  their  customers  by  thus 
accepting  drafts.  The  customer  is  responsible,  in  each 
case,  to  the  accepting  bank,  and  must  reimburse  the 
latter  before  the  draft  is  due,  but  acceptance  of  the  draft 
insures  it  and  makes  it  salable.  The  Federal  Reserve 
Act  of  1913  specifically  permits  banks  which  become 
members  of  the  system  thus  to  "accept"  drafts  drawn 
upon  them,2  and  it  empowers  the  Federal  reserve  banks 
to  rediscount  the  commercial  paper  of  member  banks. 
The  law  is  intended,  doubtless,  among  other  things,  to 
further  the  development  of  a  rediscount  market. 

§9 

Summary 

Before  taking  up  a  study  of  the  forces  determining  the 
rate  (or  rates)  of  exchange,  let  us  briefly  restate  the  prin- 
cipal conclusions  regarding  exchange,  already  reached. 
First,  taking  up  our  analysis  where  it  was  left  by  the 

'See  Jacobs,  Bank  Acceptances,  National  Monetary  Commission,  1910, 
pp.  4;  9. 

2  Under  conditions  prescribed  by  the  law. 


74    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

previous  chapter,  we  saw  that  bills  of  exchange  or  drafts 
simply  extend  to  trade  between  widely  separated  dis- 
tricts the  possibilities  of  successive  debtorship  and 
creditorship  and  of  debt  cancellation,  which  in  circum- 
scribed areas  are  brought  about  through  the  use  of  checks. 
As  in  the  case  of  checks,  banks  are  really  but  inter- 
mediaries through  whom  and  by  whose  arrangements, 
cancellation  takes  place.  A  consideration  of  the  different 
varieties  of  method  in  settling  obligations  over  long  dis- 
tances served  to  reenforce  the  general  conclusion.  These 
obligations  are  usually,  settled  in  either  of  two  ways : 
first,  the  creditor  may  draw  a  draft  upon  his  debtor 
payable  to  the  creditor's  bank  or  to  some  other  desig- 
nated party;  second,  the  debtor  may  purchase  a  bank 
draft  with  which  to  remit  to  his  creditor.  Assuming,  in 
trade  between  England  and  the  United  States,  either  of 
these  methods  to  be  used  from  both  sides,  or  assuming 
one  method  from  one  side  of  the  water  and  another  from 
the  other  side,  we  reach  alike  the  same  result.  The  use 
of  drafts  and  the  intermediation  of  banks  make  possible 
an  international  network  of  credit  relations  which  could 
not  otherwise  exist.  The  usual  practice  is  for  American 
creditors  to  draw  on  their  English  debtors  and  for  Ameri- 
can debtors  to  remit  to  their  English  creditors. 

When  the  various  ways  of  settling  obligations  through 
the  use  of  bills  of  exchange  had  been  set  forth,  we  were 
ready  to  inquire  of  what,  in  any  country,  the  supply  of 
drafts  upon  another  country  is  made  up.  We  found 
it  to  be  composed  of  two  classes  of  drafts :  those  drawn 
by  the  creditors  of  the  first  country  upon  their  debtors 
in  the  second,  offered  for  sale  to  exchange  bankers ;  and 
those  made  out  by  banks  in  the  first  country  upon  their 
correspondent  banks  in  the  second,  sold  to  debtors  in  the 


METHOD  OF  FOREIGN  EXCHANGE  75 

first  country  who  desire  to  make  remittances  to  the 
second.  Demand  for  drafts,  also,  proved  to  have  a  two- 
fold source,  springing,  on  the  one  hand,  from  debtors 
desiring  bank  drafts  for  remittance  and,  on  the  other, 
from  banks  desiring  commercial  or  bank  drafts  to  settle 
with  or  maintain  balances  in,  correspondent  banks. 
Analysis  of  the  relations  involved  made  it  clear  that 
supply  in  one  country  (or  territory)  of  drafts  upon  a 
second,  brings  about  demand  in  the  second  for  drafts  on 
the  first. 

The  exchange  market  was  briefly  described  and  it  was 
shown  how  exchange  dealers  make  a  profit  from  their 
transactions,  being  able  to  buy  exchange  somewhat  more 
cheaply  and  sell  it  at  somewhat  higher  rates,  than  mer- 
chants, manufacturers,  etc.  Next,  bills  of  exchange  were 
classified  as  sight  drafts  and  long  bills,  according  to  the 
time  to  elapse  before  payment,  and  as  documentary  bills 
and  clean  bills,  according  as  documents,  such  as  a  bill 
of  lading,  do  or  do  not  secure  them ;  and  documentary 
bills,  other  than  those  payable  at  sight,  were  in  turn 
subdivided  into  acceptance  bills  and  payment  bills  ac- 
cording to  what  conditions  the  drawee  must  fulfill  to 
secure  goods  consigned  to  him. 

Finally,  the  process  of  selling  demand  drafts  against 
remittances  of  long  bills  was  briefly  described.  It  was 
pointed  out  that  this  can  be  done  by  American  banks 
by  sending  drafts  on  English  firms  to  England  for  dis- 
count ;  but  that  in  the  absence  of  a  rediscount  market 
here,  the  reciprocal  operation  is  unusual.  Instead,  long 
drafts  on  American  firms,  in  those  relatively  infrequent 
cases  when  they  are  drawn,  are  generally  held  till  ma- 
turity for  account  of  the  remitting  London  banks.  The 
comparatively  large  discounting,  in  England,  of  bills 


76    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

drawn  by  Americans  on  their  English  debtors,  means 
that  the  capital  which  enables  the  Americans  to  get 
immediate  funds,  comes  largely  from  those  other  Eng- 
lishmen or  English  banks,  who  buy  these  bills  in  the 
discount  market,  or  from  the  depositors  of  the  banks 
where  the  funds  for  purchasing  the  drafts  are  secured. 


CHAPTER  IV 
THE  RATE  OF  EXCHANGE 

§i 

The  Meaning  of  Par  of  Exchange 

BILLS  of  exchange  or  drafts  are  certificates  of  property 
rights,  i.e.  they  certify  rights  to  payment  and,  therefore, 
rights  to  enjoy  the  benefits  of  various  amounts  of  wealth. 
These  rights,  like  other  property,  are  subjects  of  purchase 
and  sale,  and  have  a  price  in  any  market  where  they  are 
bought  and  sold.  Also,  the  ruling  price,  at  any  time,  of 
drafts,  like  the  price  of  other  goods,  is  fixed  by  supply  and 
demand. 

Exchange  between  countries  may  be  said  to  be  at 
par  when  a  demand  draft  on  either  country  sells  in  the 
other  for  the  equivalent  in  coin  of  its  face  value,  plus 
or  minus  only  the  insignificant  expense  of  banking  ser- 
vice.1 For  instance,  the  mint  par  between  England  and 
the  United  States  is  £i  =  $4.8665.  This  means  that 
the  material  (gold  11/12  fine)  in  an  English  pound  ster- 
ling of  full  weight,  is  just  equal  in  value,  supposing  both 
to  be  in  the  same  place,  to  the  material  which  would 
be  contained  in  $4.8665  of  gold  coinage  (9/10  fine)  of 
the  United  States.  Exchange,  therefore,  would  be  at 
par  between  England  and  the  United  States  if  a  demand 
draft  on  London  for  £100  was  worth,  in  New  York, 

1For  a  bank  might  be  purchasing  good  commercial  sight  drafts  for  very 
slightly  less  and  selling  its  own  drafts  for  very  slightly  more. 

77 


78    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

$486.65.  In  domestic  exchange,  say  between  New  York 
and  Chicago,  par  of  exchange  is  $i  =  $i,  for  the  standard 
of  value  is  in  both  places  exactly  the  same. 

The  rate  of  exchange,  however,  may  go  above  or  fall 
below  par.  Sight  or  demand  drafts  for  the  same  amount 
may  realize  different  sums  on  different  dates.  Our 
problem  is  to  explain,  by  a  study  of  supply  and  demand, 
why  the  rate  of  exchange,  e.g.  between  England  and  the 
United  States,  ever  varies  from  par,  and  why  it  is  fluc- 
tuating rather  than  steady. 

§2 

The  Supply  of  and  the  Demand  for  Bills  of  Exchange 

At  the  beginning  of  our  discussion  on  the  rate  of  ex- 
change, it  is  important  to  get  clearly  in  mind  the  mean- 
ing, in  this  connection,  of  the  terms  " supply"  and 
"demand."  In  talking  about  other  goods,  e.g.  wheat, 
we  insist  that  " supply"  means  supply  at  a  price,  and 
that  "demand,"  likewise,  means  demand  at  a  price. 
Adopting,  here,  an  analogous  sense,  we  may  say  that 
the  supply,  in  the  United  States,  at  a  given  price  or  rate 
and  for  any  given  period,  of  drafts  on  England,  is  the  total 
of  those  drafts  which  sellers  would  part  with,  at  that 
price  or  rate.  The  supply  of  bills  tends  to  increase  as 
the  price  or  rate  rises  and  to  decrease  as  the  rate  falls.1 
On  the  other  hand,  the  demand,  in  the  United  States, 
at  a  given  price  or  rate  and  during  any  given  period,  for 
drafts  drawn  upon  English  firms,  is  the  total  of  such 
drafts  which  buyers  of  drafts  stand  ready  to  purchase 
at  that  price.  The  demand  for  drafts  tends  to  rise  as 
the  price  or  rate  falls  and  to  fall  as  the  rate  rises.2  As,  in 

1  See  §§  4,  5  of  this  Chapter  (IV  of  Part  I),  §§  i,  3  of  Ch.  V  (Part  I),  §  9  of 
Ch.  VI  (Part  I).  2  Ibid. 


THE  RATE  OF  EXCHANGE  79 

the  United  States,  we  have  a  supply  of  and  a  demand  for 
bills  of  exchange  on  England,  so,  in  England,  there  is 
a  supply  of  and  a  demand  for  such  bills  on  the  United 
States.  Since  the  rate  of  foreign  exchange  is  fixed  by 
supply  and  demand,  at  the  point,  of  course,  where  supply 
and  demand  are  equal,  we  have  next  to  determine  what 
forces  affect  supply  and  what  forces  affect  demand,  and 
how  these  forces  operate. 

The  supply,  in  this  country,  of  drafts  upon  any  foreign 
country  or  upon  all  foreign  countries  together,  is  deter- 
mined by  obligations,  agreements  or  desire  of  foreigners 
to  make  payments  to  us.1  This  is  obviously  the  case 
with  commercial  drafts  drawn  on  foreign  purchasers  of 
American  goods.  These  drafts  come  into  our  exchange 
market  because  foreign  debtors  are  under  business  obli- 
gations to  the  makers  of  the  drafts.  But  it  is  no  less 
true  of  bank  drafts  drawn  to  accommodate  American 
debtors  wishing  to  remit.  The  bank  draft  is  drawn 
upon  a  foreign  bank  which  is,  or  which  puts  itself,  un- 
der obligation  to  pay  to  the  American  bank's  order.  A 
draft  drawn  on  a  foreign  bank  wishing  to  lend  here  for 
profit,  is  determined  by  desire  of  the  foreign  bank  so 
to  invest.  All  drafts,  therefore,  offered  for  sale  in  our 
market,  are  based  on  the  necessity  which  foreigners  are 
under  or  their  desire  to  make  payments  to  some  of  us. 

Conversely,  the  demand  here  for  drafts  on  foreign 
countries,  is  determined  by  our  obligations  to  them  and 
by  our  occasion  to  make  voluntary  payments  to  them. 
This  demand,  as  we  have  seen,2  has  a  twofold  source. 
It  comes  from  business  houses,  etc.,  which  wish  to  buy 
bank  drafts  for  remitting  to  their  creditors  and  other 

1  See,  however,  paragraph  after  next. 
»  Chapter  III  (of  Part  I),  §§  4,  5- 


8o    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

persons  abroad;  and  it  comes  from  American  banks 
which  wish  to  buy  commercial  drafts  for  remitting  to 
their  correspondents.  These  American  banks  have 
occasion  to  remit,  largely  to  maintain  foreign  balances 
on  which  to  sell  their  own  drafts,  but  partly  because 
English  firms  have  drawn  upon  American  debtors  and 
settlement  must  be  made  through  American  banks  to 
which  the  drafts  on  Americans  have  been  sent  for  col- 
lection. These  American  banks  will,  therefore,  wish  to 
buy  drafts  on  England  in  order  to  remit.  The  more 
usual  practice,  as  we  have  seen,1  is  for  our  English  credi- 
tors to  await  remittances  by  their  American  debtors, 
in  drafts  on  London. 

So  far  as  foreign  debtors  choose  to  settle  by  remitting 
drafts  on  American  banks,  obligations  from  abroad  to 
us  do  not  increase  the  supply,  here,  of  drafts  on  for- 
eign countries.  But  the  effect  on  the  rate  of  exchange 
is  the  same,  for  our  banks,  by  honoring  these  drafts, 
in  so  far  are  relieved  from  the  necessity  of  buying  drafts 
on  foreign  countries  to  keep  square  with  their  foreign 
correspondent  banks.  In  other  words,  there  is  a  de- 
crease, here,  of  demand  for  drafts  on  foreign  countries, 
instead  of  an  increase  of  supply.  But  the  rate  of 
exchange  is  affected  in  the  same  way  and  to  the  same 
extent  in  either  case. 

The  supply,  here,  of  drafts  on  foreign  countries,  may 
be  said  to  depend,  chiefly,  on  the  following  sources  of 
obligation  and  voluntary  payments  from  them  to  us, 
though  some  of  the  obligations  are  more  likely  to  be 
settled  by  remittance  and  therefore  to  increase  demand 
abroad  for  drafts  on  the  United  States  and  decrease 
demand  here  for  drafts  on  foreign  countries,  rather  than 

i  Chapter  III  (of  Part  I),  §  5. 


THE  RATE  OF  EXCHANGE  81 

to  increase  supply  here  of  drafts  on  foreign  countries. 
The  items  in  group  5  are  perhaps  most  likely  to  be  settled 
by  remittances.  Following  are  the  groups : 

1.  Purchase,  abroad,  of  American  merchandise. 

2.  Purchase  by  foreigners,  from  Americans,  of  trans- 
portation, banking,  insurance,  and  other  services. 

3.  Purchase,    abroad,    of    American    securities,    and 
repurchase   or   redemption    of    foreign    securities   held 
here. 

4.  Agreements  by  which  foreigners  make  short  time 
loans  to  Americans,  and  (which  amounts  to  the  same 
thing) 1  agreements  by  which  our  bankers  may  draw 
finance  bills  on  foreign  banks ;  repayment  of  such  short 
time  borrowing  done  by  foreign  banks  from  American 
banks. 

5.  Payment   of   interest,    dividends,    rent,    etc.,    on 
American   investments   abroad,    remittances   to   Euro- 
peans travelling  in  the  United  States,  etc. 

On  the  other  hand,  the  demand,  here,  for  drafts  on 
foreign  countries,  depends  in  the  main  on  corresponding 
sources  of  obligation  and  voluntary  payments,  as  follows : 

1.  Purchase,    by   Americans,    of   merchandise   from 
foreign  countries. 

2.  Purchase,  by  Americans  from  foreigners,  of  trans- 
portation, banking,  insurance,  and  other  services. 

3.  Purchase,  by  Americans,  of  foreign  securities,  and 
repurchase  or  redemption  of  American  securities. 

4.  To  make  short  time  loans  abroad,  to  repay  short 
time  loans  from  abroad  and  (which  is  fundamentally 
the  same  thing)  to  repay  obligations  incurred  by  Ameri- 
can banks  which  have  drawn  finance  bills  on  foreign 
banks. 

1  See  §§  4,  5  of  this  Chapter  (IV  of  Part  I). 
G 


82    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

5.  Payment  of  interest,  dividends,  rent,  etc.,  to 
foreigners  who  have  invested  money  here,  remittances 
to  Americans  travelling  abroad,  remittances  to  families 
abroad  of  immigrants  living  here,  etc. 

Though  the  lists  above  given  correspond,  it  must  not 
be  assumed  that  the  payments  in  one  direction  under 
any  particular  item  are  the  equivalent  of  the  payments 
under  the  same  item  in  the  other  direction.  In  many 
cases  the  difference  is  very  great.  Thus,  practically 
nothing  is  paid  by  foreigners  to  Americans  for  the  trans- 
portation of  goods,  unless  we  include  in  this  item  the 
transportation  in  the  United  States  itself,  of  goods 
eventually  to  be  shipped  abroad.  But  Americans 
pay,  every  year,  millions  of  dollars  to  Englishmen  for 
the  transportation  services  of  Great  Britain's  merchant 
marine.  Similarly,  the  balance  of  payments  for  bank- 
ing services  would  be  against  the  United  States,  since 
London  is  the  principal  banking  center  of  the  world. 
Again,  remittances  by  immigrants  in  the  United  States 
to  their  families  in  Europe  would  not  be  balanced  by 
payments  of  any  similar  nature  made  by  Europeans  to 
people  here.  Contrariwise,  payments  by  Europeans 
to  Americans  for  merchandise  might  be  considerably 
in  excess  of  similarly  caused  payments  in  the  opposite 
direction. 

Since  the  United  States  is  still,  in  large  part,  an  agri- 
cultural country,  its  exports  tend  to  be  periodic  rather 
than  uniform.  The  largest  exports,  -  from  the  United 
States  are  in  the  fall  after  the  croDSfKave  been  harvested. 
But  the  things  we  buy  flow  t^u^n  a  more  steady  stream. 
Hence  there  is,  in  the  fall,  a^Batively  large  supply  of 
drafts  on  foreign  countries,  for  sale  in  the  United  States, 
and  a  comparatively  low  price  for  them  or  low  rate  of 


THE  RATE  OF  EXCHANGE  83 

exchange.1  Banks  can  then  purchase  these  bills  more 
cheaply  as  a  rule  than  at  other  times,  and  will  therefore 
be  able  to  sell  their  own  demand  drafts  at  lower  rates. 

§3 

The  Effect  on  the  Exchange  Market  of  any  Country 
of  Disturbed  Political  or  Industrial  Conditions  in 
That  Country  and  in  Other  Countries 

Investments  for  long  periods,  nowadays,  take  place 
largely  through  the  purchase  of  stocks  and  bonds, 
though  also  through  the  purchase  of  real  estate,  the 
loaning  to  individuals  on  mortgage  security,  etc.  The 
buyer  of  a  bond  is  a  lender  to  the  government  or  company 
whose  bond  he  buys.  The  buyer  of  stock  has  a  right 
to  residual  gains.  The  entire  western  European  world 
is  now  a  possible  market  for  American  securities,  whether 
these  securities  represent  public  or  corporate  indebt- 
edness or  rights  to  corporate  profits.  To  some  extent, 
the  United  States  furnishes  a  market  for  European 
securities,  but  to  a  far  less  extent.  Europeans  have,  in 
the  past,  invested  more  here  than  Americans  have  in- 
vested in  Europe.  The  English  people,  for  instance, 

1  The  truth  of  this  statement  is  evidenced  by  statistics  compiled  by  one  of 
my  students,  Mr.  Lawrence  M.  Marks,  Yale  1914,  from  successive  volumes 
of  the  Commercial  and  Financial  Chronicle.  Taking  the  highest  and  lowest 
quotations  for  each  month,  of  exchange  on  London,  and  averaging  all  the  Janu- 
aries,  all  the  Februaries,  etc.,  for  the  years  1906-1910  inclusive,  Mr.  Marks  ar- 
rived at  the  following  results : 

January    4.872  July  4.872 

February  4.875  August       4.8685 

March      '4,8725  September  4.866 

April        4-Ws  October      4.8665 

May         4-^P[,  November  4.8695 

June         4.876  December  4.869 

Cf.  also  Clare,  The  A.  B.  C.  of  the  Foreign  Exchanges,  London  (Macmillan), 
1893,  PP-  135,  136. 


84    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

have  been  large  accumulators,  and  so  have  forced  the 
rate  of  interest  in  England  down  to  a  comparatively 
low  level.  Here,  the  rate  of  interest  has  been  higher. 
Consequently,  Englishmen  have  made  large  purchases  of 
American  securities.  And,  to  a  considerable  extent, 
they  still  hold  these  securities,  despite  the  tendency 
during  the  last  few  decades  for  American  industry  to 
be  financed  in  greater  degree  by  American  capital. 

Largely  because  of  foreign  interest  in  American  se- 
curities, the  exchange  market  may  sometimes  be  much 
affected  by  American  financial  troubles.  If,  for  a  while, 
prosperity  threatens  to  forsake  us,  many  foreign  holders 
of  our  corporate  securities  may  become  alarmed  and 
endeavor  to  dispose  of  their  holdings  even  at  sacrifice 
quotations.  American  capitalists  may  therefore  be 
induced,  to  some  extent,  to  buy  these  securities  back 
again.  So  far  as  this  effect  is  realized,  there  is  a  ten- 
dency for  the  rate  of  exchange  on  other  countries,  i.e. 
the  price  of  drafts  on  these  countries,  to  rise.  For  it 
puts  American  investors  under  obligation  to  remit  to 
those  from  whom  securities  have  been  purchased;  or, 
if  the  foreign  sellers  have  drawn  drafts  upon  America, 
then  American  banks  must  purchase  drafts  on  foreign 
countries  in  order  to  settle  with  their  correspondents. 
In  either  case,  the  demand,  here,  for  drafts  on  other 
countries  rises. 

If,  on  the  other  hand,  investments  which  Americans 
may  have  in  other  countries,  e.g.  in  Mexico  or  in  certain 
of  the  South  American  republics,  seem  to  be  rendered 
unsafe  because  of  threatened  political  disturbance  or 
open  revolution,  then  the  erideavor  of  Americans  to  dis- 
pose of  such  investments  will  |end  to  increase  the  supply 
of  drafts  on  such  countries  aiU^p  may  lower  the  rate 
at  which  these  drafts  sell. 


THE  RATE  OF  EXCHANGE  85 

§4 

Analysis  of  the  Relations  Involved  in,  and  Explanation 
of  the  Results  of,  Short  Time  Loans  Made  Ostensibly 
by  Foreign  Banks,  through  the  Intermediation  of  the 
Exchange  Market 

One  of  the  sources  given  in  our  lists,  of  the  supply  in 
one  country  of  drafts  on  another  or  others,  is  short  time 
" loans"  (e.g.  60  or  90  days)  by  banks.  Some  of  the 
banks  in  one  country  may  choose  to  "lend"1  in  another 
country.2  Let  us  suppose  that  a  London  bank,  Be, 
wishes  to  "lend,"  in  the  United  States,  the  sum  of 
$50,000.  It  would  cable  its  New  York  correspondent, 
Ba,  to  draw  on  it  a  draft  payable  in  perhaps  90  days  after 
sight.  This  draft  could  be  sold  in  New  York  to  another 
exchange  dealer  or  banker,  and  the  sum  realized  loaned, 
for  account  of  the  London  bank,  to  an  American  firm 
or  business  man. 

The  loan  made  may  be  a  so-called  "sterling"  (like- 
wise mark  or  franc)  loan,  or  it  may  be  a  "currency" 
loan.3  In  the  case  of  the  sterling  loan,  it  is  agreed  that 
the  foreign  bank  shall  receive  a  definite  commission  or 
payment  from  the  borrower,  for  allowing  him  to  raise 
money  by  a  draft  upon  it.  If  the  loan  is  a  sterling  loan, 
the  borrower  (the  American  business  house  getting  the 
use  of  the  funds)  takes  the  risk  of  fluctuation  in  the  rate 
of  exchange  during  the  life  of  the  loan.  The  American 
bank,  Ba,  draws  a  draft  on  Be  payable  to  the  American 
borrower.  This  draft  is  for  so  many  pounds  sterling. 
Hence  the  arrangement  is  called  a  "sterling"  loan. 

1  Who  is  the  real  lender  will  appear  later  in  this  section. 

2  See  descriptive  discussion  in  Escher,  Elements  of  Foreign  Exchange,  New  York 
(The  Bankers  Publishing  Co.),  19 Ji,  PP-  85,  86. 

3  Ibid.,  p.  87.  ?:• 


86    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

The  borrower,  to  whom  the  draft  is  given,  gets  his  money 
or  his  bank  credit  by  disposing  of  the  draft  at  the  best 
price  he  can  get.  When  the  90  days  are  up,  it  devolves 
upon  him  to  purchase  a  demand  draft,  payable  to  the 
lending  bank,  Be,  and  turn  it  over  to  Ba  for  remittance. 
The  lending  bank  must  honor,  at  the  end  of  the  90  days, 
the  draft  drawn  on  it  by  Ba,  for  this  will  have  reached 
London,  and  payment  will  be  due  90  days  after  pres- 
entation. But  Be  will  by  that  time  have  received  the 
bank  draft  purchased  by  the  borrower,  and  so  will  be 
able  to  pay  without  any  drain  on  its  resources.  It  has 
gone  through  the  form  of  lending  while  not  parting  with 
a  single  pound.  It  has  only  taken  upon  itself  the  obli- 
gation to  pay,  90  days  after  sight,  a  sum  which  it  was 
practically  certain  to  receive  (although  there  was,  of 
course,  some  risk)  equally  soon  from  the  American 
borrower. 

The  "currency"  loan  is  different  only  in  the  formal 
arrangements.  It  serves  the  same  purpose.  Ba  does 
not,  in  this  case,  hand  over  the  draft  on  Bc,  for  the  bor- 
rower to  sell,  but  itself  sells  the  draft  to  another  bank 
or  dealer.  It  then  gives  the  borrower  cash  or  credit 
in  terms  of  American  currency.  That  is  why  it  is  called 
a  currency  loan.  The  borrower  gets  dollars,  not  a 
claim  to  pounds  sterling  requiring  to  be  converted  into 
dollars.  When  the  time  comes  for  repayment,  the  bor- 
rower settles  with  Ba  and  J3a  settles  with  Be.  The  bor- 
rower pays  an  agreed  rate  of  interest.  The  lending 
bank,  Be,  is  subject  to  a  risjL  of  fluctuation  in  the  rate 
of  exchange.  If  this  bank 'foresees  a  probability  that 
exchange  will  fluctuate  favorably  to  it,  then  it  will  prefer 
to  make  the  currency  loan ;  if  unfavorably,  it  will  prefer 
to  make  the  sterling  loan. 


THE  RATE  OF  EXCHANGE  87 

We  have  seen  that  the  so-called  lending  bank,  Be, 
is  at  no  time  out  actual  funds  by  virtue  of  its  transac- 
tion. It  lends  only  in  name.  Yet  the  American  bor- 
rower gets  funds  in  the  form  of  cash  or  bank  account, 
and  eventually  buys  goods  with  these  funds.  Some- 
where there  is  a  real  lender,  an  ultimate  creditor.  Who 
and  where  is  he  ?  The  answer  is  :  he  is  the  man  or  firm 
who  buys  the  draft  when  it  is  offered  for  sale  in  the 
London  discount  market,  or  the  depositors  of  the  bank 
from  which  this  man  or  firm  borrowed  the  means  to 
buy.  For  the  draft  on  Be,  having  been  sold  in  the  United 
States  to  an  exchange  dealer  or  bank,  would  be  sent  by 
the  American  bank  to  its  correspondent  bank  in  London, 
and  by  the  latter  sold  to  whoever  cared  to  invest  in  it. 
This  English  investor  it  is,  or  the  depositors  of  a  bank 
from  which  he  borrows,  who  gives  up  early  income  for 
later.  He  (or  they)  is  giving  up  present  goods  for  future 
goods.  He  is  the  one,  or  these  depositors  are  the  ones, 
because  of  whose  accumulations  the  whole  transaction 
is  possible.  The  American  business  man  borrower 
gets,  if  not  cash,  a  bank  account,  just  as  if  he  borrowed 
it  from  Ba,  and  with  this  bank  account  he  buys  goods. 
But  instead  of  being  indebted  to  Ba  and  through  Ba  to 
its  depositors,1  he  is  indebted,  in  the  case  of  the  sterling 
loan,  to  Be,  through  Be  to  the  English  purchaser  of  the 
draft,  and  through  him  to  the  depositors  in  any  bank 
from  which  he  gets  the  means  to  purchase ;  in  the  case 
of  the  currency  loan,  to  Ba,  through  Ba  to  Be,  through 
Be  to  the  English  purchasers  of  the  draft,  and  finally 
to  depositors  in  this  purchaser's  bank.  The  English 
bank  is  but  a  nominal  lender.  The  English  (or  other) 
purchaser  of  the  draft  in  the  London  discount  market, 

i  See  Ch.  II  (of  Part  I),  §  3. 


88    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

and,  in  the  last  analysis,  the  depositors  in  his  bank,  are 
the  real  lenders.  In  Chapter  II  we  saw  that  commercial 
banking  combines  and  coordinates  sporadic  convenience 
waiting  so  as  to  make  available  to  borrowers  in  the  form 
of  loans,  a  considerable  amount  of  this  waiting,  waiting 
which  would  in  any  case  be  done  because  of  convenience, 
and  which,  except  for  commercial  banking,  would  be 
of  no  use  to  borrowers.  Here  we  see  that  the  sporadic 
waiting  done  by  bank  depositors  in  one  country,  may 
be  the  means  of  providing  borrowers  in  another  country, 
with  funds.  As  is  to  be  expected,  the  waiting  or  ultimate 
lending,  in  the  case  of  these  drafts,  is  done  more  largely 
abroad,  and  the  borrowing  so  made  possible  is  done  more 
largely  by  Americans. 

Foreign  loans  of  the  kinds  we  have  been  describing, 
i.e.  sterling  and  currency  loans,  may,  if  most  largely 
made  in  the  spring  and  early  summer,  help  to  tide  over 
the  periods  of  the  year  when  the  United  States  has  a 
surplus  of  payments  to  make  abroad,  so  that  these 
payments  need  not  be  so  large.  Instead  of  our  sending 
large  amounts  of  specie  abroad,  English  purchasers,  in 
the  London  discount  market,  of"  drafts  drawn  upon 
" lending"  London  banks,  and,  through  these  purchasers, 
depositors  in  English  banks,  may  become  temporarily 
our  creditors.  They  lend  to  us  by  providing,  for  a  time, 
the  capital  to  liquidate  obligations  from  us  to  English 
manufacturers  and  merchants,  obligations  for  which, 
if  we  could  not  get  temporary  credit,  specie  would  have 
to  flow.  Then  when  the  crop  season  comes  and  the 
pressure  of  obligations  is  more  markedly  the  other  way, 
we  pay  the  holders  of  these  drafts  by  transferring  to 
them  part  of  our  claims  upon  purchasers  of  our  exports. 
Instead  of  money  flowing,  first  from  here  to  England,  for 


THE  RATE  OF  EXCHANGE  89 

example,  and  then,  in  the  fall,  from  England  back  to  us, 
less  will  have  gone  either  way.1  During  the  winter, 
spring,  and  early  summer,  our  net  indebtedness  abroad 
would  perhaps  have  required  considerable  gold  ship- 
ments. But  any  drafts  drawn  during  this  period  upon 
English  banks,  nominally  lending  banks,  are  available 
for  purchase  by  American  exchange  bankers  who  must 
make  remittances  abroad.  The  shipment  of  gold  abroad 
is  thus  avoided.  Then  in  the  fall  when  we  are  selling 
considerable  amounts  of  grain  and  other  products  and 
drafts  on  England  are  low  in  price,  and  when  large  im- 
ports of  gold  might  result,  in  payment  for  our  exports 
of  wheat,  cotton,  etc.,  these  imports  of  gold  are  made 
less  by  the  fact  that  those  Americans  who  have  received 
the  temporary  loans  (or,  in  the  case  of  currency  loans, 
the  banks  which  act  for  them)  have  now  to  liquidate 
their  obligations  by  purchasing  drafts  on  London. 

The  comparatively  high  rates  of  exchange  on  England 
during  the  seasons  when  we  are  exporting  less  than  we 
are  importing,  and  the  comparatively  low  rates  in  the 
fall,  tend  to  make  these  dealings  worth  while.  Those 
who  thus  borrow  during  our  surplus  importing  season, 
e.g.  late  spring  or  early  summer,  sell  their  drafts  at  a 
relatively  high  price  and  buy  later  for  remitting,  if  in 
the  fall,  at  a  lower  price.  The  London  bank  which 
engages  in  the  operation  will  intend  to  receive  its  share 
of  the  gain  resulting  from  this  situation;  at  least  in 
the  case  of  the  currency  loan,  as  we  have  seen,2  it  clearly 
gets  the  benefit  of  a  favorable  movement  in  the  rate  of 
exchange  on  London ;  and  we  should  therefore  expect 

1  Cf .  Goschen,  The  Theory  of  the  Foreign  Exchanges,  third  edition,  London 
(Effingham  Wilson),  1896,  pp.  38-41. 

2  See  description  at  beginning  of  this  section. 


go    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

it,  other  things  equal,  to  engage  most  gladly  in  the  lend- 
ing operation  described,  at  the  very  times  when  its 
doing  so  would  avoid,  or  decrease  in  amount,  successive 
and  opposite  shipments  of  gold. 

§5 

Finance  Bills,  What  they  Are,  Whose  Accumulations  Make 
them  Possible  and  What  are  their  Results 

/ 
The  case  of  a  finance  bill  l  is  not  greatly  different  from 

that  of  a  bill  drawn  on  a  foreign  bank  which  expresses 
a  desire  to  lend.  There  is,  indeed,  a  difference,  but  it 
is  superficial  rather  than  fundamental.  In  the  case  of 
the  bill  drawn  on  a  foreign  lending  bank,  the  foreign 
bank  is  lending  as  an  investment  for  its  own  profit. 
In  the  case  of  the  finance  bill,  the  drawing  is  done  for 
the  convenience  and  profit  of  the  drawing  bank,  in  our 
illustration  the  American  bank.  In  this  case,  the  Eng- 
lish bank  does  not  request  the  American  bank  to  draw 
on  it  to  the  end  that  the  English  bank  can  profit  by  so- 
called  lending.  On  the  contrary,  the  American  bank 
gets  the  permission  of  the  English  bank  to  draw  a  draft 
on  the  latter.  For  in  the  case  of  the  finance  bill  the  Eng- 
lish bank  is  under  no  obligation  to  the  American  bank. 
The  latter,  therefore,  has  no  right  to  draw  a  draft  on  the 
former  except  by  permission.  Arrangement  is  accord- 
ingly made  between  the  banks.  The  American  bank, 
Ba,  is  given  the  right  to  draw  on  the  English  bank,  Be, 
in  return  for  a  fee  or  commission.  Ba  then  draws  on 
Be,  sells  the  draft  in  the  market,  and,  for  the  time  being, 
e.g.  90  days,  has  the  use  of  so  much  extra  currency. 

1  Escher,  Elements  of  Foreign  Exchange,  pp.  94-98,  gives  a  brief  description 
of  the  finance  bill. 


THE  RATE  OF  EXCHANGE  91 

Ba's  credit  is  good  enough  so  that  Be  is  willing  to  "accept" 
the  draft  or  drafts,  in  confidence  that  when  the  90  days 
after  sight  are  up,  and  payment  is  demanded,  it  will 
already  have  received  remittance  from  Ba.  It  will  at 
no  time  be  out  any  money.  The  finance  bill  is  therefore 
not  greatly  unlike  the  class  of  bills  previously  described, 
drawn  on  foreign  lending  banks. 

As  in  the  case  of  the  lending  operation,  so  in  the  case 
of  the  finance  bill  above  discussed,  some  American  (or 
Americans),  is  borrowing  from  abroad.  In  the  case 
of  the  finance  bill,  the  borrower  is  the  American  bank 
which  gets  the  9o-day  control  of  currency,  and,  through 
the  bank,  any  person  or  persons  who  are  thus  enabled 
to  borrow  from  it.  Here,  as  before,  the  real  lender  is 
the  person,  or  firm,  in  England,  who  purchases  the  draft 
in  London,  whither  it  has  been  sent  for  sale  in  the  dis- 
count market,  and  through  him  the  depositors  in  the 
English  bank  or  banks,  whose  convenience  waiting  gave 
him  the  means  to  invest  in  the  draft.  Ba  owes  Be,  but  Be 
owes  this  holder  of  its  draft,  and  he,  in  turn,  is  indebted, 
through  a  bank  as  intermediary,  to  the  depositors  of 
that  bank,  whose  convenience  waiting  provided  him 
with  the  means  of  purchase. 

Like  the  short-term  loan  operation,  the  finance  bill  — 
also  really  a  loan  from  abroad  —  may  serve  to  tide  over 
a  period  of  surplus  imports,  so  that  gold  need  not  so 
largely  be  shipped  out  at  one  season  of  the  year  only 
to  be  shipped  back  again  in  a  couple  of  months.  If, 
in  the  spring  and  early  summer,  when  we  are  perhaps 
importing  largely  and  exporting  less,  and  have,  there- 
fore, a  surplus  indebtedness,  our  banks  are  allowed  to 
draw  finance  bills,  these  drafts  come  into  the  market 
and  are  available  for  use  in  paying  off  part  of  the  balance 


92    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

of  obligations.  We  therefore  pay  previous  obligations 
by  making  new  ones.  Considered  as  a  nation,  we  post- 
pone payment;  for  what  one  group  of  persons  pays, 
another  group  has  borrowed.  Then,  in  the  fall,  when 
there  would  otherwise  be  a  balance  of  obligations  from 
others  to  us,  this  balance  is  diminished  by  our  postponed 
obligations  to  them.  Not  only,  then,  are  there  smaller 
shipments  of  gold  abroad  in  the  earlier  period,  but  also 
there  are  smaller  return  shipments  at  the  later.1 

It  needs,  however,  to  be  demonstrated  that  finance 
bills  will  most  probably  be  drawn  by  American  banks 
at  those  times  when  we  have  a  balance  of  obligations  to 
meet,  thus  relieving  the  pressure,  and  serving,  as  above 
suggested,  to  obviate  the  necessity  of  gold  shipments. 
The  theory  of  individualism,  as  distinguished  from  so- 
cialism, is,  that  in  serving  their  own  interest,  men  are, 
in  their  economic  activities  (except  where  certain  un- 
fair methods  of  business  are  improperly  permitted,  or 
certain  classes  of  wealth  or  income  not  really  earned  are 
unwisely  secured  to  individuals),  serving  the  public 
interest.  Let  us  see  how  the  individualistic  philosophy 
applies  in  this  case.  In  that  part  of  the  year  when  the 
United  States  owes  largely,  the  price  in  the  United 
States  of  exchange  on  foreign  countries,  is  high.  It 
pays  Ba,  therefore,  to  draw  finance  bills,  and  sell  them 
at  this  high  price.2  On  the  other  hand,  the  excess  of 
obligations  towards  us  in  the  fall,  and  the  consequent 
excess  of  drafts  on  foreign  debtors,  for  sale  here,  makes 
the  price  of  these  drafts  at  that  time  low.  Ba  can  there- 
fore buy  drafts  to  repay,  at  a  low  price.  If  necessary, 

1  Goschen,  The  Theory  of  the  Foreign  Exchanges,  pp.  38-41 ;  also  Bastable, 
The  Theory  of  International  Trade,  fourth  edition,  London  (Macmillan),  1903,  p.  78. 

2  Or  itself  forward  them  for  discount  and  credit  abroad. 


THE  RATE  OF  EXCHANGE  93 

the  loan  can  be  renewed  by  the  drawing  of  a  new  draft 
to  replace  the  old,  in  cases  where  it  is  some  time  before 
the  rate  falls.  Ba  therefore  profits,  besides  the  interest 
which  can  be  earned  during  the  time  it  can  invest  or 
loan  the  amount,  by  the  difference  between  the  price 
of  the  drafts  at  one  time  and  another,  minus,  of  course, 
Be's  commission.  Such  drafts  are,  therefore,  other 
things  being  equal,  most  likely  to  be  drawn  by  profit- 
seeking  banks  at  the  very  times  when  they  will  serve 
the  purpose  of  avoiding  gold  shipments.1 

§6 

How  a  Bank  in  One  Country  and  a  Bank  in  Another  May, 
through  the  Aid  of  the  Exchange  Market,  Invest  in 
One  of  the  Countries  for  Joint  Account,  without  Either 
Bank  Using  its  Own  Funds 

Another  variety  of  this  species  of  draft  is  that  some- 
times drawn  when  an  American  and  a  foreign  bank  in- 
vest here  on  joint  account.2  Ba  may  see  that  it  can  pur- 
chase certain  securities  cheaply  at  the  time,  securities 
which  can  probably  be  sold,  later,  at  a  substantial 
profit.  But  Ba  has  use  for  all  the  funds  under  its  own 
immediate  control,  and  does  not  wish  to  invest  any  of 
these  funds  in  such  securities.  It  suggests,  therefore, 
to  its  English  correspondent,  Be,  that  both  go  into  this 
investment,  on  joint  account,  securing  the  means  through 
the  use  of  exchange.  Ba  then  draws  on  Be  a  draft  matur- 
ing in  say  90  days  after  sight,  which  is  sold  in  New  York. 
With  the  proceeds  the  securities  are  purchased  and  held 

1  Cf.  Clare,  The  A. B.C.  of  the  Foreign  Exchanges,  1803,  p.  86;  also  Escher, 
Elements  of  Foreign  Exchange,  p.  97,  and  Margraff,  International  Exchange, 
Chicago  (The  Fergus  Printing  Co.),  1903,  p.  39. 

8  Process  described  in  Escher,  Elements  of  Foreign  Exchange,  pp.  133-135. 


94    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

for  90  days  or  perhaps  a  less  period.  They  are  then  sold, 
presumably  at  a  profit,  and  remittance  is  made  to  Be. 
The  draft  on  Be  was  purchased  in  New  York,  sent  to 
London,  and  sold  in  the  London  discount  market.  By 
the  time  the  purchaser  presents  it  to  Be  for  payment, 
Ba  has  remitted.  Neither  bank  has  sacrificed  the  use 
of  its  own  funds.  As  in  the  other  cases,  the  capital  is 
really  furnished,  in  the  last  analysis,  by  the  purchaser, 
in  the  London  discount  market,  who  has  bought  the 
draft,  or,  in  all  probability,  by  the  depositors  of  a  bank 
from  which  the  purchaser  borrowed  the  means  to  make 
the  investment.  Thus  it  is  that  an  American  and  an 
English  bank  can  invest  here,  for  joint  account,  in  securi- 
ties, without  either  of  them  providing  the  means.  The 
capital  is  really  put  up  by  an  Englishman  or  Englishmen, 
but  not  by  the  English  bank  on  which  the  bill  is  drawn. 
As  in  the  case  of  lending  by  a  foreign  bank  and  the  case 
of  the  finance  bill,  so  here,  there  would  be  some  addi- 
tional stimulus,  other  things  equal,  to  the  drawing  of 
such  drafts  on  foreign  banks  at  those  times  of  the  year 
when  drawing  them  would  decrease  the  shipments  of 
gold. 

§7 

Analysis  of  the  Relations  Involved  in  a  Letter  of  Credit 

The  exportation  and  the  importation  of  goods  may 
often  be  greatly  facilitated  by  so-called  letters  of  credit.1 
These  letters  of  credit  make  possible  the  drawing  of 
bills  of  exchange  on  other  parties  than  the  actual  debtors, 
and  at  times  such  an  arrangement  is  very  helpful.  As 
above  suggested,  this  form  of  commercial  credit  may  be 
used  to  further  either  import  or  export  trade.  Since 

1  Described  by  Escher,  Elements  of  Foreign  Exchange,  pp.  143-160. 


THE  RATE  OF  EXCHANGE  95 

it  will  facilitate  importation  and  since  exportation  by  us 
is  importation  by  some  other  country,  it  must  facilitate 
exportation  also. 

The  use  of  a  letter  of  credit  is  as  follows.  A  man 
importing  goods,  say  from  South  Africa  into  the  United 
States,  desires  to  get  possession  of  them  at  once,  but  is 
not  in  a  position  to  pay  for  them  until  he  can  himself 
dispose  of  them  for  currency.  He  cannot,  therefore, 
pay  for  them  by  remitting  a  bank  draft.  On  the  other 
hand,  the  South  African  exporter  desires  to  receive  his 
pay  immediately.  The  American  importer  goes  to  his 
bank,  say  Ba,  and  asks  for  a  letter  of  credit.  If  the 
circumstances  warrant  it,  Ba  issues  such  a  letter,  which 
is  in  the  form  of  a  request  on  Be,  the  London  corre- 
spondent of  Ba,  to  accept,  up  to  a  given  amount  and 
under  specified  conditions,  the  drafts  of  the  South  , 
African  exporter.  The  London  bank  is  informed  that>' 
such  a  request  on  it  has  been  issued  to  the  importer. 
The  American  importer  sends  this  letter  to  South  Africa, 
and  the  exporter  there  is  then  in  a  position  to  draw  a 
draft  on  the  London  bank,  Be,  instead  of  on  the  Ameri- 
can importer  or  his  bank,  Ba.  If  the  draft  is  drawn  for 
90  days  after  sight,  the  American  importer  has  that 
length  of  time  to  settle.  The  goods  are  billed  to  his  v 
bank,  Ba,  which  issued  the  letter  of  credit;  and  the 
bank  will  probably  let  him  take  over  the  goods  upon  his 
signing  a  trust,  receipt  securing  the  bank.  The  draft 
drawn  in  South  Africa  is  sent  to  London,  presented, 
"  accepted,"  and  sold  in  the  discount  market.  The  bill 
of  lading  and  insurance  certificate  were  attached  to  the 
draft  to  begin  with,  but  when  the  latter  is  "accepted" 
the  London  bank  detaches  all  documents  and  sends 
them  to  the  New  York  bank  so  that  the  goods  may  be 


96    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

secured  upon  arrival.  By  the  time  the  draft  is  due,  the 
American  importer  has  paid  his  bank  and  it  has  settled 
with  the  London  bank.  This  then  is  another  illustra- 
tion of  borrowing  by  a  business  man  or  business  men  in 
the  United  States,  the  real  lender  or  creditor  being  the 
purchaser  of  the  draft,  in  the  London  discount  market, 
and  through  him  the  depositors  in  some  English  bank. 

One  of  the  chief  reasons,  in  fact,  for  the  use  of  a  letter 
of  credit,  is  to  enable  the  exporter  to  draw  on  London 
or  some  other  well-known  banking  centre.  His  draft 
will  then  bring  the  highest  possible  price.  London, 
as  the  principal  banking  and  exchange  centre  of  the 
world  and  a  great  exchange  discount  market,  is  most 
frequently  the  place  drawn  on.  The  exporter  can  get 
immediate  payment 1  and  the  importer  can  get  credit. 

§8 

Place  Speculation  or  Arbitraging  in  Exchange 

Just  as  there  may  be  place  speculation  and  time  specu- 
lation in  the  case  of  commodities,  so  both  of  these  types, 
of  speculation,  or  something  analogous  to  them,  exist 
in  the  case  of  drafts.  Corn  may  be  sent  from  a  place 
where  it  is  relatively  cheap  to  a  place  where  it  is  rela- 
tively dear.  This  is  arbitraging  in  corn.  Similarly 
there  is  arbitraging  in  exchange.2  Arbitraging  in  ex- 
\  ,  change  involves  the  purchase  of  drafts  on  one  place  and 
the  sale  of  drafts  on  another.  Thus,  if  in  New  York 
exchange  on  London  is  high  while  exchange  on  Paris  is 

1  If  the  letter  of  credit  is  "confirmed"  by  the  bank  made  drawee,  then  pay- 
ment is  absolutely  guaranteed  to  the  exporter,  even  before  his  bill  is  "accepted." 
See  Margraff,  International  Exchange,  Chicago  (Fergus  Printing  Co.),  1903,  pp, 
88,  89. 

2  Described  in  Escher,  Elements  of  Foreign  Exchange,  pp.  98-101. 


THE  RATE  OF  EXCHANGE  97 

low ;  and  if  in  Paris,  exchange  on  London  is  fairly  low, 
an  arbitraging  transaction  would  be  profitable.  The 
arbitrager  in  New  York  would  buy  exchange  on  Paris, 
would  instruct  his  Paris  correspondent  to  buy  exchange 
on  London,  and  would  then  be  able  to  sell  in  New  York, 
exchange  on  London.  Thus  the  cheaper  exchange  on 
London,  available  in  Paris,  is  shifted  to  New  York. 
Exchange  on  London  is  sold  from  Paris  where  it  is  cheap, 
to  New  York  where  it  is  dear.  This  activity  by  arbi- 
tragers, of  course,  tends  to  limit  the  variations  in  price 
at  different  places,  of  exchange  on  any  one  point.  It 
is  seldom  possible  to  make  a  very  considerable  per  cent 
gain  by  such  transactions. 

§9 

Time  Speculation  in  Exchange 

Besides  arbitraging  or  place  speculation,  there  is 
also  time  speculation  in  exchange.  As  with  produce, 
e.g.  wheat,  this  speculation  in  time  may  be  speculative 
holding,  buying  and  selling  of  futures,  and  (a  part  of 
future  selling)  selling  short.  Suppose  a  New  York  bank 
to  purchase  bills  of  exchange  on  London  and  to  send 
them  over  for  discount  (i.e.  sale),  either  for  immediate 
discount  or  for  discount  as  occasion  requires.  The 
New  York  bank  is  then  accumulating  in  England  a  basis 
for  its  own  drafts.1  If,  at  the  time,  bills  of  exchange 
on  England  are  purchasable  at  a  low  price,  the  New 
York  bank  will  be  more  likely  to  buy,  and  later,  when 
exchange  is  higher,  it  will  be  under  greater  temptation 
to  sell.  If  the  New  York  bank  buys  exchange  when  the 

1  Cf.  Clare,  The  A, B.C.  of  the  Foreign  Exchanges,  p.  87 ;  and  Escher,  Elements 
of  Foreign  Exchange,  p.  30. 


98    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

rate  is  low,  then  its  buying  tends  to  keep  up  the  rate, 
and  when  it  later  sells,  at  relatively  high  prices,  its  sell- 
ing tends  to  keep  the  rate  down.  This  kind  of  trans- 
action, therefore,  acts  on  the  exchange  market  just  as 
speculative  holding  of  wheat  acts  on  the  wheat  market, 
namely  in  the  direction  of  equalization.  Such  specula- 
tive holding  of  exchange,  in  so  far  as  it  exists,  serves  to 
decrease  the  alternate  import  and  export  of  gold.  When 
exchange  here,  on  England,  is  low  because  of  the  excess 
of  obligations  from  them  to  us,  a  part  of  this  excess  of 
obligations  may  take  the  form  of  available  credit  for 
American  banks  with  English  banks.  So  much,  there- 
fore, of  the  excess  of  obligations,  need  not  be  settled  by 
the  shipment  of  gold.  Later,  when  gold  tends  to  flow 
from  the  United  States  to  England,  this  accumulated 
credit  in  England  obviates  the  necessity  of  so  great  a 
flow  of  gold  as  would  else  occur.  We  may  say  that, 
since  part  of  the  money  which  was  collectible  by  Ameri- 
can banks  (though  perhaps  collectible  only  through 
the  London  discount  market),  is  allowed  to  remain  as 
a  credit  in  England,  either  as  bank  credit  or  as  long  bills 
not  discounted  but  held  for  account  of  American  banks,1 
the  later  obligations  to  England  are  paid  partly  by  draw- 
ing on  that  credit  instead  of  shipping  gold. 

There  is  also  the  buying  and  selling  of  futures  in 
exchange.  To  illustrate,  an  exporter  may  know  long 
in  advance  that  he  is  to  ship  goods  of  a  certain  value 
at  a  given  time.  He  will  then  be  able  to  draw  a  draft 
on  the  purchaser  of  these  goods.  But  if  he  waits  until 
he  has  sold  the  goods  before  making  any  arrangements 
regarding  his  draft,  he  simply  takes  the  risk  of  selling 

1  For  further  explanation  of  the  nature  and  method  of  these  transactions,  see 
Ch.  VI  (of  Part  I),  §  2. 


THE  RATE  OF  EXCHANGE  99 

the  draft  on  his  debtor  for  whatever  is  the  ruling  price 
at  the  time  of  the  sale.  He  can,  however,  contract 
ahead  for  the  disposal  of  his  draft  to  some  exchange 
dealer  or  banker,  at  an  agreed  price.1  He  is  selling  or 
agreeing  to  sell  future  exchange. 

Sometimes  a  bank  remits  drafts  to  its  foreign  corre- 
spondent, some  of  which,  being  payment  bills,  cannot 
be  immediately  discounted  for  cash.2  These  bills  will, 
of  course,  with  few  if  any  exceptions,  eventually  be  paid ; 
and  if  there  are  very  many  of  them,  then  the  remitting 
bank  can  estimate,  because  of  the  constancy  of  averages, 
at  about  what  dates  they  will  be  paid.  This  bank  is 
therefore  in  a  position  to  promise  that  it  will  sell  demand 
drafts  on  its  correspondent  abroad,  at  given  dates  and 
for  given  amounts.  It  promises  to  sell  these  drafts 
at  some  future  time  when  it  can  be  sure  of  having  the 
balance  abroad  on  which  to  draw.3  In  this  case  the 
future  selling  is  done  by  a  bank.  By  making  such  an 
arrangement,  the  bank  guards  itself  against  the  risk 
of  unfavorable  exchange  rate  fluctuations.  By  selling 
futures  against  futures  a  bank  can  relieve  itself  entirely 
from  risk  of  such  fluctuations.  The  bank  buys  or  con- 
tracts to  buy,  an  exporter's  future  bills,  and  at  the  same 
time  sells  or  contracts  to  sell,  its  own. 

As  in  other  dealing,  so  in  foreign  exchange,  one  kind 
of  "future"  selling  is  selling  "short."  To  sell  "short" 
is  to  agree  to  sell  at  a  future  time,  without  having,  at 
the  time  of  making  the  agreement,  the  means  to  deliver, 
but  relying  upon  later  purchases  to  "cover"  the  shortage. 
A  man  sells  wheat  short  if  he  contracts,  say  in  March, 

1  See  Escher,  Elements  of  Foreign  Exchange,  p.  35. 

»  See  Ch.  Ill  (of  Part  I),  §  7. 

3  Escher,  Elements  of  Foreign  Exchange,  p.  101. 


ioo    THE  EXCHANGE  MECHANISM  OF  COMMERCE 

to  sell  for  May  delivery,  counting  on  his  ability  to  pur- 
chase the  wheat  in  May,  in  order  to  make  good  the  agree- 
ment. Similarly  an  exchange  dealer  sells  short  if  he 
agrees  to  sell  a  draft,  e.g.  in  June  for  August  delivery, 
but  has,  when  the  contract  is  made,  no  bank  balance 
abroad  or  salable  drafts  held  in  his  name  in  some  foreign 
bank,  on  which  he  may  draw.  He  relies  upon  August 
purchases  of  bills  to  provide  this  foreign  balance.  The 
same  in  principle  as  short  selling  is  the  finance  bill  al- 
ready described,  and  other  similar  bills.  In  the  case  of 
the  finance  bill,  one  bank  does  not  merely  promise  to 
sell  at  a  future  time ;  it  actually  does  sell,  in  the  present, 
a  draft  on  another  bank  where  it  has  at  the  time  no 
credit  balance  and  no  deposit  of  discountable  bills. 
This  draft,  though  sold  in  the  present,  is  of  course  for 
future  payment.  It  is  a  draft  for  60  or  90  days  or  for 
some  other  period.  It  requires  to  be  "  covered  "  before 
maturity.  Hence  it  may  properly  be  classed  with  or 
alongside  of  other  short  selling. 

§  10 
Summary 

The  starting  point  of  our  discussion  of  the  rate  of 
exchange  has  been  supply  and  demand.  At  any  given 
time  the  price,  say  in  New  York,  of  drafts  on  London, 
i.e.  the  rate  of  exchange  on  London,  is  fixed  where  supply 
of  and  demand  for  such  exchange  are  equal.  Thus, 
exchange  may  go  above  or  below  par,  the  mint  equiva- 
lent in  coinage. 

Going  back  of  supply  and  demand,  we  found  that 
these  depend  upon  purchases  and  sales,  investments, 
interest  and  dividends,  etc.  Whatever  tends  to  increase 


THE  RATE  OF  EXCHANGE  101 

the  total  payments  to  be  made  by  Americans  to  English- 
men tends  to  increase  the  demand  here  for  drafts  on 
England.  Vice  versa,  whatever  increases  the  total 
payments  to  be  made  from  them  to  us  increases  the 
supply  here  of  drafts  on  England  (or  decreases  the  de- 
mand). 

Analysis  of  the  short  time  loan  by  a  foreign  bank,  of 
the  so-called  finance  bill,  and  of  investment  here  by  an 
American  and  a  foreign  bank  for  joint  account,  led  to 
the  conclusion  that  in  all  cases  the  borrower  was  the 
business  firm  here  which  profited  by  the  loan,  while  the 
ultimate  lender  was  the  person  in  the  London  or  other 
discount  market  who  bought  the  bill  and  held  it  till 
maturity,  or  the  depositors  of  the  bank  from  which  such 
a  buyer  obtained  the  means  of  purchase.  In  the  case 
of  some  of  these  bills,  most  of  all,  perhaps,  the  finance 
bill,  there  is  probably  a  tendency  for  more  to  be  sold, 
other  things  equal,  at  those  times  of  year  when  gold 
must  otherwise  be  more  largely  exported;  and  to  be 
redeemed,  later,  when  gold  must  otherwise  be  more 
largely  imported.  The  letter  of  credit  is  a  scheme  to 
get  immediate  payment  for  an  exporter,  a  period  of 
credit  for  an  importer,  and  a  chance  for  the  exporter 
to  make  out  a,  draft  on  an  important  financial  centre  and 
therefore  a  more  salable  draft  than  he  might  else  have. 
As  with  the  finance  bill,  short  time  loan,  etc.,  the  credit 
is  really  furnished  by  investors  or  by  bank  depositors 
in  the  discount  market  of  the  big  banking  centre,  most 
likely  London,  where  the  draft  is  sold. 

Exchange  is  speculated  in,  much  as  are  wheat,  corn, 
stocks,  etc.  There  may  be  arbitraging  in  exchange,  i.e. 
sending  exchange  on  some  point,  from  where  it  is  rela- 
tively cheap  to  where  it  is  relatively  dear.  Exchange 


102  TEE  'EXCHANGE  MECHANISM  OF  COMMERCE 

may  be,  in  a  sense,  held  for  a  rise,  thus  tending  to  steady 
the  exchange  market  and  decrease  the  flow  of  specie; 
it  is  subject  to  " future"  dealings;  it  is  sold  "short." 
The  finance  bill  is  really,  in  principle,  a  kind  of  short  sell- 
ing of  exchange.  An  agreement  to  sell  at  some  future 
date,  relying  upon  purchases  of  exchange  in  the  mean- 
while, to  cover,  is  clearly  selling  short. 


CHAPTER  V 
THE  RATE  OF  EXCHANGE  AND  THE  FLOW  OF  SPECIE 

§' 

The  Upper  Limit  to  Fluctuation  of  the  Rate  of  Exchange, 
Determined  by  the  Cost  of  Exporting  Specie    v/^ 

WE  have  seen  that,  by  the  use  of  finance  bills  and  other 
similar  arrangements,  the  excessive  obligations  of  a 
country  to  other  countries  during  any  short  period  may 
be  in  part  balanced  by  the  reverse  obligations  of  a  later 
period.  We  have  also  seen  that,  by  speculative  holding 
(accumulation)  of  exchange,  the  surplus  obligations  to  a 
country  during  an  earlier  period  may  be  used  to  offset, 
in  part,  the  obligations  incurred  by  it  in  a  later.  But 
sometimes  there  will  be  a  net  balance  of  obligations  in  one 
direction  for  several  months  or  a  year  or  a  series  of  years. 
If  so,  the  obligations  probably  will  not  be  liquidated  for 
the  most  part  by  postponement  or  by  exchange  accumu- 
lation. The  demand  for  bills  with  which  to  meet  a  long 
continued  balance  of  indebtedness  will  hardly  be  satisfied 
by  the  sale  of  finance  bills  or  other  bills  of  similar  nature, 
for  the  bankers  of  a  country  cannot  be  indefinitely  add- 
ing to  their  obligations  of  this  sort  and  not  repaying. 
Neither  will  the  supply  of  bills  caused  by  a  long  continued 
excess  of  obligations  to  a  country  be  taken  care  of  by 
speculative  purchase  and  holding  for  a  rise,  since  there  is 
a  limit  to  the  amount  which  bankers  can  afford  to  invest 
in  such  speculative  holding.  If,  therefore,  our  obliga- 

103 


io4  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

tions  are  larger  for  any  great  length  of  time  than  the 
obligations  to  us,  there  will  be  a  great  demand  for  bills  of 
exchange  with  which  to  remit  and  there  will  be  a  relative 
scarcity  of  such  bills.  Consequently,  the  price  of  bills 
or  the  rate  of  exchange  on  other  countries,  which  will 
equalize  supply  and  demand,  must  maintain  a  fairly  high 
average.  On  the  other  hand,  if  obligations  to  us  are  for 
a  long  period  in  excess,  the  rate  of  exchange  here,  on 
foreign  countries,  must  be  fairly  low,  else  the  supply  of 
drafts  on  these  countries  will  exceed  the  demand. 

Are  there  any  limits,  upper  and  lower,  to  the  rate 
exchange  may  reach  ?  Are  there  any  limits,  for  instance, 
upper  and  lower,  to  the  price  that  drafts  on  London  may 
command  in  New  York?  If  there  are,  what  forces 
determine  these  limits  ? 

Let  us  consider,  first,  the  question  of  an  upper  limit  of 
exchange.  The  price  in  the  United  States,  of  drafts  on 
England,  will  not  go  above  par  by  much  more  than  the 
cost  of  shipping  specie.  For  if  it  does  so,  either  the 
demand  for  such  drafts  will  decrease,  or  the  supply  will 
increase,  or  both,  to  such  an  extent  that  supply  will 
exceed  demand.  A  rise  of  exchange  above  par  by  more 
than  the  cost  of  specie  shipment  must  decrease  the 
demand  for  drafts,  because  many  of  those  in  this  country 
who  are  debtors  will,  if  their  debts  are  large,  find  it 
cheaper  to  ship  specie  than  to  buy  drafts.  It  is  true  that 
in  some  cases  the  debts  of  merchants,  etc.,  are  settled 
by  their  English  creditors  drawing  on  them.  But  if 
so,  the  bills  drawn  on  these  Americans  have  to  be  sent 
to  American  banks  for  collection  and  these  American 
banks  must  then  settle  with  the  English  banks  sending 
the  drafts.  And  if  the  rate  of  exchange  goes  above  par 
by  more  than  the  cost  of  shipping  gold,  American  banks 


RATE  OF  EXCHANGE  AND  FLOW  OF  SPECIE     105 

having  large  remittances  to  make  will  prefer  to  ship  gold 
rather  than  to  buy  for  shipment  the  more  expensive  bills 
of  exchange.  As  a  matter  of  fact,  merchants,  manu- 
facturers, etc.,  will  rarely  have  the  facilities  and  knowl- 
edge or  the  large  indebtedness  to  warrant  their  shipping 
gold,  and  will  continue  to  send  drafts.  But  debtor  banks 
frequently  do  ship  gold.  We  may  say,  then,  that  at  a 
rate  of  exchange  much  farther  above  par  than  the  cost 
of  shipping  specie,  the  demand  here  for  drafts  on  Eng- 
land (and  other  foreign  countries)  would  fall  short  of  the 
supply.  Therefore,  such  a  rate  could  not  continue. 

We  arrive  at  the  same  conclusion  from  a  study  of  the 
supply  side  of  the  market.  If  the  rate  of  exchange,  i.e. 
the  price  of  drafts,  rises  above  par  by  more  than  the  cost 
of  specie  shipment,  then  it  will  pay  some  banks,  even 
though  they  owe  nothing,  to  export  gold.  The  gold  will 
be  exported  to  a  consignee,  say  a  foreign  correspondent 
bank  in  London.  Then  the  American  bank  can  count 
on  having  a  balance  or  drawing  account  in  the  London 
bank,  in  the  same  manner  as  if  drafts  had  been  sent. 
On  this  balance,  the  American  bank  can  draw  its  own 
drafts  for  sale  in  the  United  States,  at  the  high  ruling  rate, 
to  persons  having  remittances  to  make.  By  so  doing, 
the  bank  adds  to  the  supply,  here,  of  drafts  on  England, 
and  the  ordinary  business  man  has  no  occasion,  himself, 
to  ship  gold.  So  a  rise  in  the  price  of  drafts  on  England, 
beyond  a  certain  point,  will  tend  to  increase  the  supply 
of  such  drafts.  And  at  a  price  which  exceeds  par  by  much 
more  than  the  cost  of  shipping  specie,  supply  would  al- 
most necessarily  exceed  demand,  because  the  shipment 
of  specie  on  which  to  sell  drafts  would  be  so  profitable. 
It  follows  that  the  rate  of  exchange  cannot,  ordinarily, 
be  expected  to  exceed  par  by  much  more  than  the  gold 


. 


io6  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

shipment  cost.  It  is  kept  down  by  forces  on  the  supply 
side  of  the  market,  as  well  as  by  forces  on  the  demand 
side. 

We  may  fairly  assume  the  cost  of  gold  shipment 
between  New  York  and  London  to  be,  for  large  quanti- 
ties, about  $2  per  £100,  including  charge  for  transporta- 
tion, insurance,  and  all  other  expenses.  Then,  since  par 
between  New  York  and  London  is  $486.65  =  £100,  the 
price  in  New  York  of  sight  drafts  on  London  could  not 
much  exceed  $488.65  =  £100.  So  soon  as  it  gets  as 
high  as  that  or  higher,  it  becomes  as  cheap  or  cheaper  for 
New  York  banks  to  settle  their  indebtedness  to  English 
banks  by  purchasing  and  shipping  gold  as  by  purchasing 
and  shipping  drafts.  A  draft  on  London  for  £100  would 
cost,  if  exchange  were  at  its  highest  point,  $488.65  or 
more.  But  if  $486.65  in  gold  could  be  shipped  to  London 
for  $2,  making  a  total  expense  of  $488.65,  no  New  York 
bank,  having  a  remittance  to  make,  would  pay  a  higher 
price  for  a  draft.  Hence  the  demand  for  drafts  on  Eng- 
land must  fall.  Likewise,  so  soon  as  exchange  gets 
higher  than  $488.65  =  £100,  it  becomes  profitable  for 
New  York  banks  to  purchase  gold,  ship  it  abroad,  and 
sell  drafts  drawn  on  the  credit  so  secured.  $486.65  in 
gold  plus  $2  for  shipment,  loss  of  interest,  insurance,  etc., 
makes  $488.65,  total  expense.  The  $486.65  is  worth  in 
England,  mint  equivalent,  £100.  If  a  draft  on  the 
English  consignee  for  £100  will  sell  for  more  than 
$488.65,  it  is  obviously  profitable  to  ship  gold  and  sell 
drafts.  To  ship  drafts  instead  of  gold  might  be  less 
profitable,  because  of  their  high  price.  Because  of  gold 
shipments,  the  supply  of  drafts  on  England  must  be 
greater. 

The  cost  of  gold  shipment,  however,  may,  under  the 


RATE  OF  EXCHANGE  AND  FLOW  OF  SPECIE  go]] 

pressure  of  special  circumstances^  go  far  above  $2  per 
£100;  and  this  cost  is,  therefore,  a  somewhat  elastic 
rather  than  a  definitely  rigid  limit  to  the  possible  rise 
of  exchange.  For  example,  the  prospect  of  a  great  Eu- 
ropean war  caused  insurance  rates  on  gold  shipments  to 
Europe  to  rise  as  high  as  i  per  cent  on  July  30  and  31 
of  this  year  (1914)  .*  Such  charges,  nearly  $5  per  £100 
for  insurance  alone,  at  a  time  when  there  was  a  strong 
movement  in  foreign  countries  to  sell  securities  and  real- 
ize gold,  and  when,  consequently,  the  United  States  was 
exporting  gold,  made  possible  a  rise  in  exchange  rates 
much  above  the  usual  upper  limit.  In  fact,  the  foreign 
exchange  market  seems  to  have  been,  in  this  case,  com- 
pletely demoralized  by  the  suddenness  of  the  crisis.2 
The  immediately  ensuing  outbreak  of  war  on  an  extended 
scale  brought  a  sudden  check  to  trade  in  general,  in- 
cluding the  export  of  gold.  One  vessel,  the  Kronprin- 
zessin  Cecilie  of  the  North  German  Lloyd  Company, 
which  had  left  New  York  July  28  carrying  over 
$10,000,000  in  gold  and  silver  consigned  to  English  and 
French  banking  houses,  returned  with  her  cargo  to  the 
United  States  (Bar  Harbor,  Me.,  Aug.  4)  rather  than 
risk  capture.8 

§2 

Some  Details  Connected  with  the  Exportation  of  Specie 

A  number  of  details  of  the  gold  export  operation  may 
now  claim  our  attention.  Let  us  consider  first  the  loss 
of  interest  during  transportation  of  the  gold.  If  it  takes 
seven  days  to  transport  the  gold  and  if  the  draft  drawn 
upon  it  is  sold  when  the  gold  is  shipped  and  goes  abroad 

1  See  New  York  World,  July  31  and  Aug.  i,  1914. 

*Ibid.,  July  31,  1914. 

*  New  Haven  Evening  Register,  Aug.  4,  1914. 


io8  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

at  about  the  same  time,  this  draft  can  hardly  be  honored  in 
less  than  seven  days.  The  purchaser  of  the  draft,  there- 
fore, must  pay  for  it  seven  days  before  his  foreign  creditor 
can  receive  the  money,  and  so  must  lose  seven  days  inter- 
est. The  alternative  to  such  a  purchase  would  be  to 
wait  seven  days  and  buy  a  cable.  If  he  buys  the  banker's 
draft  on  the  gold  he  will,  presumably,  pay  very  slightly 
less  for  it  in  consequence  of  this  period  of  waiting. 
Accordingly,  the  price  received  by  the  drawing  bank  is 
very  slightly  less.  Any  demand  draft,  however,  other 
than  a  cable,  must  suffer  such  a  deduction  for  interest. 
And  demand  drafts  drawn  when  goods  are  shipped,  on 
the  consignees,  cannot  usually  be  cables,  since  the  con- 
signees cannot  be  expected  to  pay  for  goods  before 
receiving  them.  Any  exporter,  then,  may  be  said  to  lose 
interest  in  the  same  way.  He  ships  goods  which  may  not 
reach  their  destination  for  several  days  or  weeks.  If  they 
arrive  on  the  same  steamer  as  his  draft  (which  is  at  once 
shipped  by  the  purchasing  American  bank),  the  draft 
may  be  made  payable  at  sight.  But  even  then  there  is 
time  lost.  Had  the  goods  been  sold  at  home,  this  loss 
need  not  have  occurred.  It  is  one  of  the  deductions  from 
the  benefits  of  trade  between  widely  separated  areas, 
that  wealth  in  transit  is  temporarily  kept  out  of  use. 
The  American  exporter  may  get  more  for  his  goods,  if 
sold  in  England,  than  he  could  get  at  home,  and  the 
English  buyer  may  get  these  goods  more  cheaply  than  if 
he  purchased  them  in  his  own  country.  This  gain  to 
both  parties  will  presumably  exceed  all  losses,  including 
the  loss  of  time,  incident  to  handling  and  transporting 
the  goods.  Otherwise  the  trade  would  not  take  place. 
But  the  cost  of  transportation  makes  the  net  gains  con- 
siderably less  than  they  would  else  be,  and  the  loss  of 


RATE  OF  EXCHANGE  AND  FLOW  OF  SPECIE     109 

time  involved  makes  them  somewhat  less.  The  exporter 
of  any  goods,  then,  may  be  said  to  lose  something  in 
interest  when  he  sells  a  sight  draft  on  the  consignee, 
though  the  price  he  receives  for  the  goods  may  make  the 
transaction  well  worth  while.  The  gold  exporting  bank 
is  no  exception.  This  slight  loss,  however,  is  not  ordi- 
narily reckoned  as  one  of  the  expenses  of  exporting  gold. 
The  banker  thinks  of  the  price  his  draft  brings,  as  his 
receipts,  and  does  not  regard  the  slight  reduction  below 
what  it  would  yield  if  collectible  at  once,  as  an  expense. 
Insurance  of  the  gold,  transportation  charges,  etc.,  are 
deductions,  along  with  the  cost  of  the  gold,  from  his  gross 
returns,  and  these  he  regards  as  his  expenses. 

When  gold  is  exported,  it  must  be  assayed,  weighed, 
etc.,  on  arrival,  and,  since  this  requires  some  three  days, 
there  must  be  subtracted  interest  for  that  time  from 
the  shipper's  gross  profit.  If  the  draft  drawn  upon  the 
gold  is  a  sight  draft,  it  may  be  presented  and  paid  three 
days  before  the  gold  shipped  can  rightly  be  credited 
to  the  drawer.  If  so,  there  is  technically  an  "overdraft" 
on  which  interest  has  to  be  allowed  by  the  American  gold 
exporting  bank1  to  the  English  consignee  bank.  That 
is,  this  interest  must  be  deducted  from  the  balance  in 
England  on  which  the  American  bank  can  draw.  When 
the  American  bank  exports  gold  as  the  cheapest  means  of 
settling  a  debt,  there  is  the  same  loss  of  time,  and  so,  in 
a  sense,  loss  of  interest,  during  assaying,  weighing,  etc., 
as  well  as  during  transit. 

Still  another  detail  should  be  mentioned.  In  New 
York,  or  at  any  United  States  sub  treasury,  gold  is  always 
purchasable  with  dollars  (e.g.  United  States  notes,  gold 

1  See  Escher,  Elements  of  Foreign  Exchange,  New  York  (The  Bankers  Publish- 
ing Co.),  IQII,  pp.  114,  115. 


no  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

certificates  or  silver)  at  the  same  rate  or  price.  An 
ounce  of  pure  gold  is  always  worth  $20.671,  and  an  ounce 
of  gold  9/10  fine  is  worth  $18.604.  The  subtreasuries 
aim  to  have  bar  gold  available,  but  if  the  supply  is 
exhausted,  then  gold  coin  can  be  secured  for  export. 
There  is  no  question,  therefore,  here,  as  to  the  cost  of  the 
gold  to  be  shipped.  But  there  is  some  variation  in  the 
amount  of  coin  of  the  realm  which  the  specie  may  be 
worth  on  arrival  in  Great  Britain.  This  is  because, 
while  the  bank  of  England  is  by  law  compelled  to  pay 
£3  175.  gd.  per  ounce  for  gold,  the  mint  equivalent  of 
an  ounce  is  £3  175.  iof<£.  Any  one  can  get  the  larger 
amount  for  his  gold  by  waiting  to  have  it  coined.  But 
on  account  of  the  delay  and  consequent  loss  of  interest 
while  the  gold  is  being  coined,  together  with  the  labor  of 
weighing  and  assaying,  the  bank  is  not  compelled  to  give 
the  mint  par  for  gold ;  though,  to  relieve  others  of  the 
necessity  of  waiting,  it  is  under  obligation  to  give  for 
it  the  somewhat  less  price  stated  above.  The  bank,  how- 
ever, may  have  sufficient  use  for  gold,  for  reserve,  export, 
or  other  purpose,  so  that  it  will  bid  the  full  mint  price  or 
even  more.  If  all  gold  coins  were  full  weight,  the  bank 
would  never  bid  more  than  the  mint  price,  since  coined 
gold  could  be  used  and  it  would  be  cheaper  to  use  coined 
gold  for  any  purpose  for  which  the  gold  bars  (or  bullion) 
might  be  desired,  than  to  pay  a  higher  price  for  the  latter. 
The  price  of  gold  would,  in  that  case,  fluctuate  between 
£3  175.  gd.  and  £3  175.  lojd.  In  fact,  it  may  and  some- 
times does  go  slightly  above  the  latter  price,  because  the 
bank  may  be  purchasing  gold  with  worn  coins,  which, 
while  within  the  legal  limit  of  tolerance  in  England, 
would  have  to  pass  by  weight  if  exported.  The  American 
bank  which  exports  gold  to  England  cannot  tell,  there- 


RATE  OF  EXCHANGE  AND  FLOW  OF  SPECIE    in 

fore,  just  what  it  will  be  worth  on  arrival  (though  doubt- 
less some  one  could  be  found  to  guarantee  a  price). 
The  money  value  on  arrival  will  depend,  slightly,  on 
what  is  being  offered  for  gold  at  the  time. 

Sometimes  the  export  of  gold  involves  a  triangular 
operation.1  For  instance,  Ba  wishes  to  get  a  balance 
with  Be  in  England,  on  which  to  sell  drafts.  Drafts 
on  England,  here,  are  high,  and  Ba  does  not  wish  to  buy 
any  in  such  a  market.  But  it  may  happen  that  in  Paris, 
drafts  on  London  are  below  par.  The  high  rate  in  New 
York  of  drafts  on  Paris,  however,  tends  to  discourage 
arbitraging.  Instead,  Ba  can  ship  gold  to  its  Paris 
correspondent,  Bf,  and  order  the  Paris  bank  to  buy  a 
draft  on  London.  This  draft  is  sent  to  London  for  dis- 
count, and  Ba  then  has  a  balance  in  London,  with  Be, 
on  which  it  can  draw  at  a  profit  above  cost. 

§3 

The  Lower  Limit  to  Fluctuation  of  the  Rate  of  Exchange, 
Determined  by  the  Cost  of  Importing  Specie 

As  the  rate  of  exchange  has  an  upper  limit,  though  of 
course  a  slightly  elastic  one,  so  also  it  has  a  lower  limit. 
If  exchange  falls  below  par  by  much  more  than  the  cost 
of  importing  specie,  either  the  supply  of  drafts  on  foreign 
countries  must  decrease,  or  the  demand  for  such  drafts 
must  increase,  or  both,  to  such  an  extent  that  sup- 
ply exceeds  demand.  The  supply  of  drafts  on  foreign 
countries  would  tend  to  decrease,  because  those  having 
collectible  debts  abroad  in  any  considerable  quantities, 
on  which  they  desired  to  realize,  would  find  it  cheaper 
to  pay  for  the  importation  of  specie  than  to  sell  at  so  great 

1  See  Escher,  Elements  of  Foreign  Exchange,  p.  120. 


ii2  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

a  discount,  drafts  on  their  foreign  debtors.  Suppose,  for 
example,  that  exchange  in  New  York  on  London  were 
below  $484.65  =  £100.  Then  any  New  York  bank,  or 
other  person,  desiring  to  call  back  funds  held  in  London 
or  to  collect  a  debt  from  there,  would  prefer  to  pay  $2 
per  £100  for  importation,  and  have  $486.65  minus  $2,  or 
$484.65  for  each  £100,  than  to  get  less  than  that  amount 
by  selling  a  draft  at  a  very  low  rate  of  exchange.  This 
applies,  of  course,  only  when  the  circumstances  (or 
agreement)  are  such  that  the  creditor  is  obliged  to  bear 
the  risk  of  exchange  fluctuations.  Otherwise,  the  debtor 
would  be  expected  to  remit  draft  or  specie.  But  wher- 
ever settlement  is  to  be  made  at,  in  this  regard,  the 
creditor's  risk  (and  this  might  be  the  case,  for  example, 
where  a  creditor  bank  has  decided  to  withdraw  funds 
which  it  has  itself  put  on  deposit  abroad),  the  effect  of  a 
very  low  rate  of  exchange  on  any  point  would  be  to 
decrease  the  supply  of  drafts  on  that  point  and  substitute 
importation  of  specie.  With  exchange  so  low,  it  would 
pay  better  for  banks  to  withdraw  their  balances  from 
abroad  than  to  sell  drafts  upon  those  balances. 

A  low  rate  of  exchange,  below  $484.65  =  £100,  would 
also  tend  to  increase  the  demand  for  drafts.  For  such  a 
rate  of  exchange  would  make  it  worth  while  to  import 
gold  for  profit.  £100  of  full  weight  English  money  would 
be  worth,  in  this  country,  $486.65.  Subtracting  $2  as 
cost  of  transportation,  insurance,  etc.,  there  is  left 
$484.65.  If  the  gold  can  be  purchased  with  a  draft  on  an 
English  bank,  a  draft  which,  because  of  the  low  rate  of 
exchange,  costs  less  than  the  above  sum,  the  operation 
is  profitable.  (It  is  not  intended  to  assert  that  the  im- 
portation of  so  small  a  sum  would  be  profitable.  Rather 
is  it  here  assumed  that  the  £100  is  only  a  part  of  a  much 


RATE  OF  EXCHANGE  AND  FLOW  OF  SPECIE     113 

larger  sum.)  The  low  price  of  drafts,  then,  stimulates 
the  demand  for  drafts  as  a  means  of  paying  for  English 
gold.  Thus,  on  the  supply  side  as  on  the  demand  side, 
there  is  a  limitation  on  the  extent  to  which  exchange  can 
fall.  In  practice,  the  ordinary  business  man  does  not 
himself  import  gold  but  takes  advantage  of  the  demand 
for  his  drafts  by  banks  which  use  the  drafts  to  pay  for 
gold.  With  importation  of  gold  from  England,  as  with 
exportation  to  England,  allowance  must  be  made  for  the 
possible  slight  fluctuation  in  the  price  of  gold  in  terms 
of  pounds  sterling. 

§4 

Circumstances  which  May  Cause   the  Rate  of  Exchange 
to  Fall  Below  what  is  Usually  its  Lower  Limit 

Although,  as  we  have  seen,  there  are  limits  to  the 
fluctuations  of  exchange,  yet  there  are  occasions  when 
the  rate  sinks  considerably  below  what  is  ordinarily 
the  gold  shipping  point,  or  so-called  specie  point.1 
These  are  times  of  panic  or  of  great  financial  disturbance, 
accompanied  by  a  relatively  large  supply  of  exchange. 
The  principles  involved  are  the  same  at  such  times  as 
always,  and  the  factors  to  be  considered  are  the  same,  but 
one  of  these  factors,  loss  of  time  or  loss  of  interest,  comes 
to  have  exceptional  importance.  If,  when  panic  con- 
ditions prevail,  sellers  of  goods  have  bills  on  foreign 
purchasers,  they  will  be  anxious  to  realize  on  these  bills 
at  once.  In  a  crisis,  both  cash  and  credit  are  relatively 
hard  to  get.2  At  the  peak  of  the  crisis,  there  is  a  so-called 
stringency.  Interest  rates  are  high.  The  sellers  of 

1  See  Goschen,  The  Theory  of  the  Foreign  Exchanges,  London  (Effingham 
Wilson),  1896,  pp.  49-52 ;  also  Bastable,  The  Theory  of  International  Trade,  Lon- 
don (Macmillan),  1903,  pp.  85,  86. 

2  See  Ch.  II  (of  Part  I),  §  7. 

I 


ii4  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

drafts  do  not  want  to  lose  interest  and  will,  therefore,  sell 
at  a  low  price  so  as  to  get  cash  immediately.  Especially 
if  their  creditors  are  pressing  them  hard  or  bank  loans  are 
difficult  to  get,  they  must  make  the  most  of  every  avail- 
able resource,  at  once.  Rather  than  wait  for  importa- 
tion of  gold,  they  would  sell  drafts  at  a  considerable 
reduction  below  the  usual  price.  It  is  the  same  when  the 
creditor  is  a  bank.  If,  at  such  a  time,  it  has  occasion 
to  draw  on  a  foreign  balance,  it  will  desire,  like  others,  to 
get  control  of  such  resources  at  once,  and  may  accept 
an  unusually  low  rate  of  exchange  rather  than  resort  to 
importation.  Neither  will  a  bank,  at  such  a  time,  be 
likely  to  import  gold  for  profit  unless  the  profit  is  excep- 
tionally great.  To  buy  gold  abroad  is  to  subject  itself 
to  a  considerable  wait  pending  the  arrival  of  the  gold, 
during  which  time  part  of  its  funds  are  unavailable  for 
other  business.  But  during  a  crisis  a  bank  is  least  liable 
to  desire,  even  temporarily,  to  part  with  funds.  It  will 
be  induced  to  do  this  only  by  hope  of  an  exceptional 
profit,  only,  that  is,  if  the  price  of  the  exchange  which  it 
must  use  to  buy  foreign  gold  is  below  the  usual  gold 
importing  point.  Some  few  creditors  may  be  in  a  posi- 
tion to  secure  immediate  payment  by  cable.  But 
those  whose  claims  are  based  on  the  export  of  goods 
cannot  expect  thus  to  be  paid  in  advance  of  the  goods' 
arrival.  Furthermore,  at  a  time  when  the  balance  of 
indebtedness  is  from  foreign  countries  to  us  (and  it  is 
such  a  time  that  we  are  considering),  a  part  of  that 
indebtedness  must  be  settled  by  shipments  of  gold  and  so 
necessarily  requires  an  interval  of  waiting  while  the  gold 
is  in  transit.  It  is  this  necessary  wait,  most  unwelcome 
at  a  time  of  stringency,  which  forces  the  rate  of  exchange 
below  the  usual  specie  point. 


RATE  OF  EXCHANGE  AND  FLOW  OF  SPECIE     115 

§5 
The  Cost  of  Money  Shipment  in  Domestic  Exchange 

It  should  be  noted  that  the  principles  of  domestic 
exchange  are  not  different  from  those  of  foreign  exchange. 
Money  has  to  be  shipped  from  one  part  of  the  United 
States  to  another,  as  it  has  to  be  shipped  between  coun- 
tries, and  it  costs  something  to  ship  it.  But  in  domestic 
exchange  the  distances  average  less  and  the  expense  is 
smaller.  The  express  companies  will  carry  $1000  from 
New  York  to  Chicago  for  40  cents.1  To  carry  $486.65 
across  the  ocean,  pay  for  insurance,  weighing,  assay- 
ing, etc.,  costs  about  $2  (in  large  quantities),  or  over 
$4  per  $1000,  making  an  expense  more  than  ten  times 
as  great. 

Of  course  even  the  trifling  charge  of  carrying  money 
about  our  own  country  might  well  affect  the  price  of  drafts 
to  that  extent,  and  in  fact  it  does  so  when  banks  buy  and 
sell  domestic  exchange  of  and  to  each  other.  But  in 
dealing  with  customers,  it  is  usual  for  the  banks  to  pay 
no  attention  to  this  expense.  On  the  contrary,  they  pay 
to  their  customers  when  buying  the  latters'  drafts,  and 
charge  them  when  selling  drafts  to  them,  a  more  nearly 
flat  rate,  which  includes  only  a  proper  fee  for  bank 
services,  reasonable  interest  for  time  elapsing  before 
maturity,  and  reasonable  insurance  for  the  possibility 
of  non-payment.  The  up  and  down  fluctuations  of  ex- 
change between  the  shipping  limits  are  borne  by  the 
banks,  and,  since  they  gain  about  as  much  by  one  set  of 
fluctuations  as  they  lose  by  the  reverse  changes,  they  just 
about  make,  on  the  average,  a  fair  return  for  their  service 
to  the  community. 

1  See  Taussig,  Principles  of  Economics,  New  York  (Macmillan),  1911,  Vol.  I, 
p.  466. 


n6  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

As  a  matter  of  fact,  such  a  small  proportion  of  the 
total  business  done  requires  shipment  of  actual  money 
that  the  expense,  considering  the  low  cost  of  domestic 
shipments,  may  well  be  regarded  as  negligible.  To 
illustrate,  a  New  York  bank  might  have  sold  $1,000,000 
of  drafts  on  Chicago  and  bought  $998,000  of  drafts  on 
Chicago.  It  might  then  be  necessary  to  ship  $2000  to 
Chicago  at  a  cost  of  80  cents.  But  this  would  be  an 
expense  for  the  entire  business  transacted,  extremely 
small,  and  the  bank  might  well  ignore  it.  At  any  rate, 
such,  in  domestic  exchange  within  the  United  States,  is 
the  custom. 

§6 

The  Long  Run  Effect  of  a  Balance  of  Payments  from  One 
Country  to  Another,  for  Commodities  or  Services 

So  far  we  have  discussed  chiefly  the  more  immediate 
effects,  upon  the  exchange  market,  of  given  conditions. 
Let  us  now  consider  some  of  the  long  run  or  ultimate 
effects.  These  depend  mainly  on  the  relative  prices 
or  levels  of  prices  of  goods  in  different  countries.  We 
have  seen  that  the  determination  of  the  level  of  prices  in 
any  country  is  expressed  in  the  equation 

MV  +  M'V  =  pq  +  p'q'  +   etc., 

where  M  is  money,  M'  is  bank  deposits,  V  and  V  are 
velocities  of  circulation,  the  p's  are  the  prices  respectively 
of  different  kinds  of  goods,  and  the  q's  are  the  quanti- 
ties of  these  goods.  We  have  seen,  also,  that  M '  tends 
to  increase  or  decrease  in  sympathy  with  M.  We  have, 
therefore,  drawn  the  conclusion  that  if,  in  any  country, 
M  increases  faster  than  the  q's,  prices  will  rise,  while 
if  M  decreases,  they  will  fall. 


RATE  OF  EXCHANGE  AND  FLOW  OF  SPECIE     117 

Bearing  in  mind  these  facts,  let  us  now  consider  the 
long  run  influences  of  the  following  sources  of  exchange, 
on  the  rate  of  exchange  and  on  the  flow  of  money : 
a  — Payments  for  commodities. 
ar  -—  Payments  for  services,  e.g.  freight,  banking,  etc. 
b  — Payments  of  funds  for  investments,  e.g.  interna- 
tional lending  and  investing. 

c  —  Payments  of  interest,  dividends,  etc.  on  such  invest- 
ments. 

cf  —  Payments  from  home  funds  to  persons  of  one  sec- 
tion or  country,  travelling  in  others. 
c"-  -  Payments  to  families  of  immigrants. 

Regarding  payments  for  commodities,  it  is  to  be  noted 
that  these  are  generally  purchased  where  they  can  be  got 
most  cheaply.  If  we  can  buy  most  commodities  more 
cheaply  in  England  than  here,  then  there  will  be  a  demand 
for  exchange  on  England  with  which  to  pay  for  them, 
and  exchange  on  England  will  rise.  If  such  a  condition 
(large  purchases  from  England)  lasts  for  any  great  while, 
the  rate  of  exchange  will  probably  go  high  enough  to 
encourage  the  exportation  of  gold.  As  a  consequence, 
since  in  each  country  there  is  a  relation  between  gold 
bullion  and  money,1  M,  and  therefore  M'  also,  will 
increase  in  England  and  decrease  here.  Prices  will  rise 
there  by  comparison,  and  fall  here.  We  shall  cease  to 
buy  so  much  in  England,  and  England  will  buy  more  of 
us.  Great  purchases  by  us  of  foreigners  tend,  therefore, 
to  cause  great  purchases  by  foreigners  of  us.  Money 
flows  one  way  or  the  other  because  commodities  are  pur- 
chased, all  things  considered,  where  they  are  cheapest. 
Briefly,  commodities  are  bought  where  prices  are  low; 
the  rate  of  exchange  elsewhere  on  these  low  price  places 

1  See  Ch.  I  (of  Part  I),  §  7. 


n8  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

is  therefore  high ;  gold  is  therefore  shipped  to  the  low 
price  places,  and,  since  it  is  in  large  part  coined,  because 
of  the  law  of  flow  between  bullion  and  coin,  prices  in 
those  places  tend  to  rise.  Though  equilibrium  is  ever 
being  departed  from,  it  is  ever  tending  to  be  restored. 

But  this  does  not  mean  that  if,  for  instance,  wheat  is 
cheaper  in  the  United  States  than  in  England,  and  Eng- 
land buys  wheat  of  us,  we  then,  when  English  prices 
have  fallen  and  ours  have  risen,  begin  in  turn  to  buy 
wheat  of  England.  Wheat  never  becomes  cheaper  there 
than  here.  What  is  more  likely  to  happen  is  that,  when 
our  prices  rise  and  theirs  fall,  they  will  buy  less  of  our 
wheat  than  before,  and  either  raise  more  themselves, 
buy  more  elsewhere,  use  a  substitute,  or  simply  get  along 
with  less.  We,  on  the  contrary,  when  prices  have  fallen 
in  England  and  risen  here,  will  perhaps  buy  more  cotton 
cloth  in  England,  and  either  make  less  here,  buy  less  else- 
where than  in  England,  substitute  it  for  another  kind 
of  cloth,  or  use  more  cloth. 

A  purely  superficial  consideration  might  lead  to  the 
conclusion  that  we  can  always  buy  goods  in  England  more 
cheaply  when  exchange  on  England  is  low.  A  lot  of 
English  goods  worth  £100  or,  in  our  money,  at  the  mint 
equivalent,  $486.65,  might  cost  $489  if  exchange  were 
high  and  only  $484  or  some  $5  less,  if  exchange  on  Eng- 
land were  low.  But  the  conclusion  that  low  exchange  on 
England  means  an  opportunity  to  buy  goods  there  more 
cheaply  applies  with  certainty  only  on  the  supposition 
that  other  things  are  equal.  And  the  very  fact  that 
exchange  on  England  is  low  is  evidence  that  other  things 
are  not  equal.  Low  exchange  on  England  indicates,  as 
we  have  seen,  a  large  supply  of  drafts  on  England. 
Therefore  it  probably  indicates  that  we  have  been  selling 


RATE  OF  EXCHANGE  AND  FLOW  OF  SPECIE     119 

to  England  a  relatively  large  amount  and  buying  from 
England  a  relatively  small  amount  of  goods.  The  pre- 
sumable cause  of  this  situation  is  relatively  high  prices 
there  and  relatively  low  prices  here,  as  compared  with 
other  times  or  seasons.  To  be  specific,  at  the  time  when 
low  exchange  would  enable  us  to  buy  in  England  £100 
worth  of  goods  for  $484,  it  is  probable  that  prices  in 
England  are  comparatively  high  and  that  £100  will  buy 
less  there  than  at  other  times,  compared  with  what  money 
will  buy  here.  Expressing  the  fact  in  general  terms,  we 
may  say  that,  when  money  has  flowed  from  here  to 
England  in  such  quantities  as  to  make  their  prices  higher 
and  ours  lower,  it  pays  to  sell  to  them  rather  than  to  buy 
from  them,  even  though,  at  such  a  time,  exchange  on 
England  is  below  par.  Low  exchange  on  foreign  coun- 
tries does  tend  to  stimulate  importation,  and  high 
exchange  to  stimulate  exportation,  but  exchange  fluc- 
tuations are  too  narrow  to  be  of  determining  influence. 
If,  for  example,  Americans  purchase  largely  in  England, 
the  necessity  of  remitting  will  make  exchange  on  Eng- 
land high,  and  will  in  so  far  discourage  further  purchases 
from  England,  while  encouraging  sales  to  England  and 
encouraging  English  merchants  to  purchase  goods  here. 
But  exchange  cannot  rise  high  enough  to  influence,  very 
strongly,  the  importation  and  exportation  of  other  goods, 
because  so  slight  a  rise  causes  shipment  of  gold  (which, 
because  of  its  great  value  in  small  bulk,  is  inexpensive 
in  proportion  to  value,  to  ship).1  It  is  quite  likely,  then, 
that  excess  buying  of  Americans  from  abroad,  will  not 
be  checked  or  give  rise  to  corresponding  purchases  by 
foreigners  from  this  country,  until  a  flow  of  gold  has 
changed  relative  price  levels. 

i  Cf.  Ch.  VI  (of  Part  I),  §  9. 


120  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

Payments  for  freight,  banking,  and  other  services 
affect  exchange  in  the  same  way  as  do  payments  for 
commodities.  For  example,  payments  for  ship  trans- 
portation services  are  supposedly  made  where  these 
services  can  be  secured  most  cheaply.  Thus,  a  maritime 
nation  like  Great  Britain  could  sell  to  us  the  services 
of  her  ships;  and  the  resulting  flow  of  money  towards 
Great  Britain  and  higher  prices  there  of  various  goods, 
would  give  rise  to  their  purchase  of  such  goods,  e.g. 
wheat,  from  us.  Great  Britain  might  be  said  to  export 
transportation,  banking,  and  other  services,  and  to 
import  food. 

Summarizing  the  conclusions  of  this  section  and  com- 
bining them  with  previous  conclusions,  we  may  assert 

(1)  that  the  rate  of  exchange  in  one  country  on  another 
depends  upon  the  supply  of  and  the  demand  for  drafts ; 

(2)  that  the  supply  of  and  demand  for  drafts  depends  on 
the  direction  of  obligations  and  other  occasions  for  mak- 
ing payments  between  the  countries ;  (3)  that  the  direc- 
tion of  obligations,  etc.,  depends  largely  upon  the  surplus 
of  commodities  and  services  purchased  by  one  country 
of  another ;  and  (4)  that  the  surplus  of  commodities  and 
services  purchased  by  one  country  of  another  depends 
upon  the  relative  prices  of  those  commodities  and  ser- 
vices in  (or  as  sold  by)  the  countries  concerned. 

§7 

The  Long  Run  Effect  of  International  Investments  upon 
the  Rate  o]  Exchange  and  the  Flow  of  Money 

We  have  next  to  examine  the  long  run  effect  of  inter- 
national (or  interterritorial)  investments  upon  the  rate 
of  exchange  and  upon  the  flow  of  money.  If,  for  example, 


RATE  OF  EXCHANGE  AND  FLOW  OF  SPECIE     121 

Englishmen  invest  in  the  United  States,  if  we  borrow  of 
them  or  sell  securities  and  other  property  to  them,  what 
is  the  immediate  effect?  It  is  to  increase  the  supply, 
here,  of  drafts  on  England,  or  decrease  the  demand  for 
such  drafts,1  and  so  to  lower  the  rate  of  exchange  on 
England;  and  to  increase  the  demand  in  England  for 
drafts  on  the  United  States,  raising  there  the  rate  of 
exchange  on  us  (though  this  fact  is  obscured  by  the  cus- 
tom of  quoting  the  rate  in  England,  as  here,  in  American 
money).  Then  it  becomes  worth  while  for  American 
banks  to  import  and  for  English  banks  to  export,  gold. 
As  a  second  consequence,  therefore,  gold  flows  from 
England  to  the  United  States.  Since  much  of  this  gold, 
because  of  the  laws  of  interflow  between  gold  bullion  and 
gold  coin2  is  a  subtraction  from  English  money  and  an 
addition  to  American  money,  prices  will  tend  to  fall  in 
England  and  will  tend  to  rise  in  the  United  States. 
Then  it  will  become  profitable  for  us  to  buy  more  goods 
in  England,  while  England  will  buy  less  goods  of  us.  As  a 
next  consequence,  the  obligations  from  us  to  them  will 
be  in  excess,  and  the  rate  of  exchange  on  London  will 
rise.  Therefore,  gold  will  be  shipped  back  again  in 
return  for  other  goods.3  This  return  flow  must  continue 
until  English  and  American  prices  (supposing  no  new 
influences  to  intervene)  are  in  about  the  same  relation  as 
before  the  lending  or  investing  began.  That  means  that 
in  each  country  the  quantity  of  money  must  be  in  about 
the  same  relation  as  before  to  the  quantity  of  goods. 
Speaking  roughly,  we  may  say  that  the  invested  money 
flows  back  for  goods,  or  that  what  is  really  invested  is 

1  See  Ch.  IV  (of  Part  I),  §  2. 

2  See  Ch.  I  (of  Part  I),  §  7. 

3  See  Taussig,  Principles  of  Economics,  pp.  468-471. 


122  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

usable  capital.  If  Englishmen  invest  in  the  securities 
of  a  new  American  railroad,  what  we  really  get  from 
England  may  be  steel  rails,  engines,  etc.,  or  cloth,  coal, 
and  other  goods  to  be  consumed  by  us  while  we  are  mak- 
ing the  rails  and  engines.  International  lending  and 
investing  is  most  decidedly  a  lending  and  investing  of 
capital  wealth  in  such  forms  as  are  here  suggested,  and 
not  merely  a  flow  of  money. 

Foreign  investments  here  may,  in  fact,  take  largely 
the  form  of  usable  capital,  without  the  intermediation  of 
these  stages  of  inflow  and  outflow  of  money.  The  fall 
in  the  rate  of  exchange  on  foreign  countries,  consequent 
on  such  investments,  itself  tends  to  make  foreign  goods 
slightly  cheaper  in  terms  of  American  money  and  so  to 
encourage,  somewhat,  importation  of  usable  capital, 
even  before  the  tendency  to  importation  is  accentuated 
by  the  change  in  relative  price  levels.1  And  if  gold  does 
flow  in  to  some  extent,  the  tendency  for  it  to  flow  out 
for  other  goods  may  show  itself  so  quickly  that,  aside 
from  the  first  slight  inflow,  the  purchase  of  capital  goods 
abroad  keeps  pace  -with  the  investments  made  by 
foreigners  here.  In  effect,  the  foreign  investors  send 
us,  perhaps  almost  at  once,  capital  other  than  money. 

§8 

The  Long  Run  Effect  of  Various  Other  Payments  from 
One  Country  to  Another 

The  third  group  of  purposes  for  which  bills  of  exchange 
and  money  are  sent  from  country  to  country,  is  to  pay 
interest,  dividends,  and  profits  on  investments,  to  send 
remittances  to  persons  travelling  abroad,  and  to  send 

1  Cf.  §  6  of  this  chapter  (V  of  Part  I). 


RATE  OF  EXCHANGE  AND  FLOW  OF  SPECIE     123 

remittances  to  the  families  of  immigrants.  We  have 
just  seen  that,  when  foreigners  invest  here,  such  invest- 
ment, in  the  long  run,  is  an  investment  of  consumable 
goods,  or  of  the  machinery  of  production,  or  both. 
In  the  long  run,  what  flows  here  is  goods  rather  than 
money.  After  a  time,  interest  is  earned  on  the  bonds 
foreign  investors  have  purchased,  dividends  are  declared 
on  the  stock,  etc.  Having  secured  the  use  of  foreign 
capital,  we  must  pay  interest  on  it.  There  arises  then 
a  demand  for  exchange  on  foreign  countries  in  order  to 
pay  these  investors  their  profits.  This  demand  makes 
exchange  on  foreign  countries  high  (while  on  us  it  is 
low),  and  it  becomes  worth  while  for  gold  to  be  shipped 
from  us  to  them.  The  same  kind  of  result  occurs  if 
and  when  the  invested  capital  is  itself  repaid  (i.e.  if 
American  investors  buy  back  from  foreigners  American 
land,  securities,  etc.).  Consequently  foreign  prices 
tend  to  rise  and  ours  to  fall.  Therefore,  foreigners  buy 
more  goods  of  us  than  previously,  and  the  money  flows, 
chiefly,1  back  here.  In  the  last  analysis  the  interest 
and  dividends  received  are  practically  all  in  the  form  of 
food,  raw  material,  manufactured  goods,  etc.,  and  are 
not  merely  money. 

So,  in  the  last  analysis,  remittances  to  Americans 
travelling  abroad  and  to  the  families  of  immigrants, 
have  the  same  result.  Our  countrymen  travelling  abroad 
receive  from  home,  in  the  long  run,  not  money,  but 
goods.  Of  course  they  may  purchase  chiefly  European 

1  Not,  perhaps,  entirely,  because  the  somewhat  larger  amount  of  goods  in 
foreign  countries,  consequent  on  the  flow  back  to  us,  for  goods,  of  the  interest 
and  dividends  money,  may  require  a  little  more  money  to  be  circulated.  But 
the  rapidity  of  circulation  of  money  and  the  fact  that  it  is  the  basis  for  bank 
credit  circulating  even  more  rapidly,  would  seem  to  signify  that  a  very  large 
increase  in  the  quantity  of  goods  abroad  would  call  for  but  a  slight  increase  in 
money. 


i24  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

goods,  but,  if  so,  they  thereby  put  some  Europeans  in  a 
position  to  get  American  goods.  In  the  long  run,  it  is 
chiefly  goods  other  than  money  which  flow  in  trade. 

§9 

Summary 

Though  the  use  of  bills  of  exchange  obviates,  to  a  large 
degree,  the  necessity  of  shipping  money  or  gold,  never- 
theless, as  we  have  seen,  balances  must  be  thus  settled. 
A  continuous  balance  of  obligations  in  one  direction  will 
cause  gold  to  be  shipped,  by  affecting  the  rate  of  exchange. 
It  will  become  cheaper  to  settle  indebtedness  by  shipping 
gold,  and  the  exportation  or  importation  of  gold  may  be 
undertaken  for  profit.  A  high  rate  of  exchange,  here,  on 
any  country,  will  cause  shipments  of  gold  to  that  country ; 
a  low  rate  will  cause  importations  of  gold  from  that 
country.  Exportation  of  gold  to  any  country  will  tend 
to  keep  down  the  price  of  drafts  on  that  country  by 
decreasing  the  demand  for  them  (debts  being  settled  by 
gold)  and  by  increasing  the  supply  of  them  (drafts  being 
drawn  on  consignees  when  gold  is  shipped  for  profit). 
Importation  of  gold  from  any  country  will,  analogously, 
tend  to  keep  up  the  price  of  drafts  on  that  country  by 
decreasing  the  supply  of  drafts  (gold  being  imported 
instead  of  drafts  being  drawn),  and  by  increasing  the 
demand  for  them  (to  purchase  foreign  gold  imported  for 
profit).  The  rate  of  exchange  can,  therefore,  go  above 
or  below  par  by  only  about  the  cost  (with  perhaps  a 
reasonable  profit)  of  shipping  specie.  But  at  a  time  of 
stringency,  when  most  business  men  in  a  country  desire 
to  secure  funds  as  quickly  as  possible,  the  rate  may  go 
somewhat  lower  than  what  would  usually  be  the  gold 
importing  point. 


RATE  OF  EXCHANGE  AND  FLOW  OF  SPECIE     125 

In  the  long  run,  specie  tends  to  flow  to  those  places 
where  other  desired  goods  are  cheapest  (and  specie, 
therefore,  of  most  value  or  purchasing  power  in  com- 
parison with  those  goods),  and  from  places  where  goods 
other  than  money  are  high.  So  lending  and  investing 
between  countries  is  really,  in  the  main,  a  lending  and 
investing  of  capital  goods  rather  than  money ;  for  the 
flow  of  money  changes  the  relative  levels  of  prices  of  the 
countries  concerned,  and  brings  about  a  reverse  flow. 
The  same  principle  applies  to  the  payments  of  interest 
and  dividends,  remittances  to  persons  abroad,  etc.  The 
use  of  bills  of  exchange  and  money  complicates  these 
business  relations  of  countries  and  territories;  but  it 
does  not  change  the  essential  fact  that  trading,  lending, 
investing,  and  profiting  involve,  in  the  last  analysis, 
capital  and  consumable  goods  rather  than  money. 
Money  (as  well  as  bills  of  exchange,  etc.)  is  a  part  of  our 
machinery  of  production,  but  only  a  part,  and  it  is  as  a 
part  of  this  machinery  that  k  is  of  use  in  international 
and  interterritorial  business  relations. 


CHAPTER  VI 

FURTHER  CONSIDERATIONS  REGARDING  THE  RATE  OF 
EXCHANGE 


The  Price  of  Long  Drafts  Determined  in  Part  by  the  Rate 
of  Interest  or  Discount 

THE  price,  here,  of  bills  of  exchange  on  any  given 
country,  at  a  given  time,  may  be  regarded  as  being  made 
up  chiefly  of  two  factors.  These  are,  the  rate  of  interest 
or  discount,  and  the  pure  rate  of  exchange.  The  pure 
rate  of  exchange  is  the  rate  on  demand  or  sight  drafts. 
As  to  these  there  is  no  element  of  time  except,  of  course, 
the  time  required  for  the  carriage  of  the  drafts  from  the 
one  country  to  the  other.  Ignoring  the  slight  interest 
thus  involved,  some  -£$  of  the  yearly  rate,  we  may  say 
that  the  rate  of  exchange  on  sight  drafts  is  pure  exchange. 
It  is  the  rate  of  exchange  on  sight  drafts,  which  we  have 
in  mind  when  we  say  that  exchange  can  ordinarily  fluc- 
tuate only  between  the  specie  points  or  shipping  limits. 

But  with  other  drafts,  the  rate  of  interest  or  discount 
is  an  important  fact  to  consider.  Many  of  these  drafts 
are  drawn  to  run  for  periods  of  60,  90,  and  even  120 
days  after  sight.  Since  payment  on  such  a  draft  can- 
not be  required  before  maturity,  the  investing  pur- 
chaser of  the  draft  is  in  the  position  of  a  lender  or  in- 
vestor until  then,  unless,  of  course,  he  sells  to  another. 
As  a  lender  or  investor,  he  will  wish  to  get  interest  on  his 
investment,  and  since  the  amount  he  is  to  receive  at 

126 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    127 

maturity  is  definitely  fixed,  he  can  secure  interest  only 
by  paying  somewhat  less  than  this  amount  when  he  buys 
the  draft.  In  short,  the  investing  purchaser  must  dis- 
count the  draft  for  the  time  it  has  to  run,  and  the  amount 
of  this  discount  will  depend  upon  the  rate  of  discount  or 
the  rate  of  interest.  Since  the  investing  purchaser  is 
sure  to  discount  the  draft,  the  exchange  bank  which  buys 
it  in  the  first  instance,  intending  to  have  it  sold  in  the 
exchange  market,  must  also  discount  it.  Thus,  even 
if  exchange  here,  on  England,  were  above  par,  say 
$488.65  =  £100,  a  draft  for  £100  having  some  time  to 
run  might,  because  of  the  element  of  time,  be  selling 
for  $482. 

It  may  be  noted  in  passing  that  an  importer  can,  in 
effect,  secure  a  cash  discount  on  his  purchases  by  remit- 
ting a  6o-day  or  go-day  draft.  Suppose  he  has  pur- 
chased £100  worth  of  goods  in  London,  payment  to  be 
made  in  90  days.  If  it  is  agreed  that  he  shall  remit,  he 
can,  just  before  maturity  of  the  debt,  buy  a  draft  and 
send  it.  But  he  can  also,  if  he  prefers,  buy  immediately 
a  draft  payable  in  90  days.  If  he  does  this,  he  will  get 
the  draft  at  a  discount.  His  goods  will  cost  him  less 
because  he  is  prepared  to  pay  at  once.  As  a  matter  of 
fact,  banks  frequently  sell  such  time  drafts  to  importers. 

§2 

How  Long  Drafts  on  Foreign  Countries  are  Held  as  Invest- 
ments by  American  Banks 

The  fact  that  many  drafts  run  for  periods  of  several 
months  and,  being  purchased  at  a  discount,  yield  interest 
to  the  holders  of  them,  makes  these  drafts  desirable  as 
short  term  investments.  Sometimes  the  bank  which 


128  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

originally  purchases  long  drafts,  in  the  " drawing" 
country,  prefers  to  realize  this  interest,  rather  than  to 
have  such  drafts  sold  at  once  in  the  discount  market  of 
the  "accepting"  country.  Let  us  suppose  that  for  a 
time  the  discount  rate  on  safe  drafts,  in  the  German 
market,  is  7  per  cent,  while  conditions  of  business  in  the 
United  States  are  such  that  American  banks  cannot 
earn  more  than  about  5  per  cent  on  their  capital  used 
at  home.  Under  these  conditions,  an  American  bank 
purchasing  drafts  on  Germany,  having  some  time  to  run, 
would  probably  not  send  them  to  Germany  for  imme- 
diate discount  at  the  comparatively  high  rates  there 
prevailing ;  but  would  be  more  apt  to  hold  them  in  its 
own  vaults,  or  have  them  held  for  its  account  by  its 
German  correspondent,  until  maturity  or  near  maturity, 
in  order  to  realize  a  larger  sum. 

Before  describing  the  method  of  procedure  commonly 
followed  when  drafts  on  foreign  countries  are  held  in  its 
own  vaults  for  investment  by  an  American  bank,  it  is 
essential  to  note  that  bills  of  exchange  or  drafts  used  in 
international  trade,  are  generally  made  out  in  duplicate, 
the  different  copies  being  known  as  firsts  and  seconds. 
This  has  long  been  the  custom  in  such  trade,  as  a  safe- 
guard against  possible  loss  or  miscarriage  of  one  of  the 
drafts.  Whichever  draft  first  reaches  its  destination  is 
presented  for  acceptance,  and  when  it  is  paid  the  debt 
is  cancelled.  Extra  copies  of  bills  of  lading  and  other 
documents  may  also  be  made. 

Consider  now  the  procedure  which  may  be  followed  by 
the  investing  American  bank  in  holding  the  drafts  on 
Germany.1  On  the  day  of  purchase  by  an  American 

1  Described  in  Margraff,  International  Exchange,  Chicago  (Fergus  Printing 
Co.),  1903,  p.  61. 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    129 

bank  of  drafts  on  German  banks  or  merchants,  the 
"firsts"  of  these  drafts  or  bills  of  exchange  are  not 
indorsed  by  the  American  bank  to  the  order  of  its 
German  correspondent,  as  would  be  done  if  the  drafts 
were  to  be  sent  over  for  immediate  discount  and  credit 
or  for  holding  abroad  subject  to  cable  order.  On  the 
contrary,  there  are  written  on  the  faces  of  these  firsts 
the  words  "for  acceptance  only."  Then  the  German 
correspondent  bank  to  which  the  drafts  are  forwarded, 
is  requested  to  have  them  "accepted,"  and  to  hold  them 
subject  to  the  call  of  the  seconds  properly  indorsed  by 
the  American  bank.  Any  duplicate  documents,  such  as 
duplicate  bills  of  lading,  attached  to  the  seconds,  are 
detached  and  sent  to  the  German  correspondent  bank, 
which  is  instructed  to  turn  these  documents  over  to 
the  drawees  provided  the  latter  accept  the  drafts.  The 
seconds,  clean  of  all  other  papers,  are  kept  by  the  invest- 
ing American  bank.  On  the  face  of  each  of  these  seconds 

is  written:  "Accepted  firsts  held  by ,"  giving  the 

name  of  the  bank  to  which  the  firsts  were  sent.  The 
American  bank  gets  as  profit  the  difference  between  the 
discounted  value  paid  for  the  drafts  and  the  amount 
realizable  from  them  at  maturity,  minus  the  corre- 
spondent's commission. 

When  the  date  of  maturity  approaches,  the  American 
bank  will  indorse  the  seconds,  presumably  to  the  above 
described  correspondent  bank,  and  forward  them  to  it  for 
credit.  As  a  matter  of  fact,  the  American  bank  need  not, 
if  it  prefers  otherwise,  send  the  indorsed  seconds  to  the 
foreign  bank  which  holds  the  firsts.  The  seconds  can, 
if  occasion  requires,  be  indorsed  to  any  bank,  for  the 
firsts  are  held  subject  to  the  call  of  the  indorsed  seconds, 
and  must  be  handed  over  (or  credited,  as  the  case  may  be) 


130  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

on  presentation  of  these  indorsed  seconds.1  The  two 
together  constitute  a  completed  bill. 

The  drafts  may  be  so  indorsed  and  forwarded  to  the 
correspondent  bank  for  discount  and  credit  at  any  time 
when  rates  of  discount  make  it  seem  profitable  to  send 
them.2  They  are  not  necessarily  held  until  maturity. 
But,  in  any  case,  the  amount  realized  (minus  commis- 
sion) is  placed  to  the  American  bank's  credit,  and  it  can 
then  sell  drafts  on  this  credit.  Of  course,  the  investing 
bank  takes  some  risk  of  fluctuations  in  the  rate  of  ex- 
change. If  the  rate  falls,  the  bank  will  get  somewhat 
less  when  it  sells  its  drafts  on  this  credit.  If,  on  the 
other  hand,  the  rate  of  exchange  on  Germany  was  low 
when  the  American  bank  bought  the  drafts  for  invest- 
ment, so  that  they  could  be  purchased  more  cheaply, 
and  is  high  when  the  bank  is  ready  to  sell  its  own  drafts 
on  the  credit  secured  (at  maturity  or  before),  then  the 
bank  will  realize  an  additional  profit. 

But  the  American  bank,  even  if  desiring  to  avail  itself 
of  higher  interest  rates  existing  temporarily  in  Germany, 
will  often  prefer  to  indorse  the  drafts  it  has  purchased 
to  its  German  correspondent,  and  have  them  held  by  the 
latter,  after  acceptance,  subject  to  instructions  by  cable. 
An  advantage  of  this  method  lies  in  the  possibility  of 
immediate  sale  at  any  time  before  maturity  if  low  dis- 
count rates  make  it  desirable  to  have  the  drafts  sold.  If 
to  have  them  sold  does  not  appear  to  be  profitable,  they 
can  be  retained  till  maturity  for  account  of  the  remitting 
bank. 

1  Margraff,  International  Exchange,  p.  65.  » Ibid.,  p.  63. 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    131 

§3 

Influence  on  the  Price  of  Long  Drafts,  of  Interest  Rate 
in  Drawing  Country  and  of  Interest  Rate  in  Country 
Drawn  Upon 

We  have  seen  that  the  prices  of  bills  of  exchange,  other 
than  sight  bills,  depend  upon  the  rate  of  interest.  We 
have  also  seen  that  bills  of  exchange  involve  two  trading 
countries ;  and  in  the  previous  section  attention  has  been 
called  to  the  fact  that  the  rate  of  interest  in  one  such 
country  may  be  different  from  the  rate  of  interest  in  the 
other.  Which  of  the  two  rates  of  interest  or  discount 
will,  in  such  a  case,  determine  the  price  of  a  bill  of 
exchange  drawn  in  one  country  on  the  other  ?  1 

In  the  first  place,  let  us  suppose  interest  to  be  com- 
paratively high  in  the  country  where  the  bill  in  question  is 
drawn,  say  the  United  States,  and  comparatively  low  in 
the  country  on  which  it  is  drawn,  say  England.  On 
this  assumption,  the  amount  of  the  discount,  and, 
therefore,  the  price  of  the  draft,  will  depend  on  the  rate 
of  interest  or  discount  in  the  country  on  which  the 
draft  is  drawn,  viz.,  England.  For  if  the  rate  of  discount 
in  England  is  very  low,  then  the  draft  will  sell,  in  England, 
for  a  high  price,  that  is,  for  a  price  comparatively  near 
the  maturity  value.  And  since  it  will  thus  sell  in  the 
English  discount  market  for  a  high  price,  therefore  the 
American  bank  which  first  allows  cash  for  it  to  a  mer- 
cantile or  other  establishment,  can  afford  to  pay  a  high 
price  for  the  draft.  The  American  bank  which  buys  the 
draft  does  not  need  to  wait  until  maturity  to  realize  on  it, 
but  can  have  it  discounted  immediately  on  its  arrival 

1  The  reasoning  here  followed  is  that  of  Goschen,  The  Theory  of  the  Foreign 
Exchanges,  third  edition,  London  (Effingham  Wilson),  1896,  p.  137- 


i3  2  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

at  London.  The  American  bank  does  not  need  to  lose, 
for  a  long  period,  the  use  of  its  capital.  As  a  conse- 
quence, competition  among  American  banks  will  force 
up  the  price  of  such  drafts  to  somewhere  near  what  they 
will  bring  in  the  English  discount  market.  Our  conclu- 
sion must  be  that  if  the  interest  rate  in  the  country 
drawn  upon  is  the  lower,  this  interest  rate  determines  the 
price  of  long  drafts  in  the  drawing  country  also. 

But  suppose,  on  the  other  hand,  that  the  rate  of  inter- 
est is  higher  in  the  country  drawn  upon,  say  England, 
than  in  the  drawing  country,  the  United  States.  On  this 
hypothesis,  a  draft  on  England  would  be  discounted  in 
England  at  a  comparatively  high  rate,  that  is,  would 
bring  a  relatively  low  price.  Would  its  price  be  equally 
low  in  the  drawing  country?  Certainly  if  the  pur- 
chasing bank  in  the  United  States  intended  to  send  the 
draft  at  once  abroad  for  discount,  such  a  bank  could  not 
afford  to  pay  more.  To  do  so  would  mean  a  definite 
loss.  But,  on  our  present  hypothesis,  a  draft  purchased 
at  the  low  price  based  on  the  discount  rate  in  England, 
will  yield  a  greater  return  on  the  investment  than  the 
prevailing  rate  of  interest  in  the  United  States,  the  draw- 
ing country.  Competition  among  banks  in  the  drawing 
country,  desiring  to  invest  in  such  bills  of  exchange,  may, 
therefore,  raise  the  price  of  the  draft  slightly  above  its 
value  in  the  country  drawn  upon ;  for  even  then  it  will 
bring  a  larger  return  by  way  of  interest  than  is  being 
realized  generally  in  the  drawing  country.  The  seller 
of  the  draft  may  hope  to  get  for  it  a  little  more  than  the 
price  it  would  bring  in  England,  while  the  purchasing 
bank  realizes  more  than  the  rate  of  interest  in  the  United 
States,  enough  more  to  induce  this  bank  to  buy  and  hold 
the  draft  as  an  investment,  or  have  it  held  for  its  account 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    133 

abroad.  When,  therefore,  the  rate  of  interest  is  lower 
in  the  drawing  country,  the  price  of  the  draft  will  be 
determined,  at  least  in  small  part,  by  that  rate  of  interest. 
It  should  be  added  that  if  conditions  change  during  the 
life  of  a  draft,  so  that  interest  is  lower  in  England,  such 
a  draft  held  here  as  an  investment  is  likely  to  be  sent 
there  for  immediate  discount  at  the  high  price  realizable. 
As  a  matter  of  fact,  the  discount  rate  in  London,  as 
also  in  other  great  European  centres,  is  almost  always 
lower  than  in  New  York.  The  usual  rule,  therefore,  is 
for  American  banks  to  have  their  drafts  on  England 
discounted  there  at  once.  Their  capital  can  be  more 
profitably  invested  at  home  than  in  holding  long  drafts 
on  English  debtors.  On  the  other  hand,  English  banks 
do  not  have  long  drafts  which  they  buy  on  Americans, 
discounted  in  the  United  States.  The  absence,  here,  of 
a  rediscount  market,  makes  it  practically  impossible  for 
them  to  do  this,  though  the  usually  higher  rates  of  dis- 
count prevailing  in  the  United  States  might,  in  any  case, 
disincline  them  to  have  such  drafts  sold  on  this  side. 
There  are,  in  practice,  very  few  long  bills  drawn  upon 
the  United  States,  and  such  long  bills  as  are  drawn  upon 
this  country  are  usually  held  till  maturity,  for  account 
of  the  foreign  remitting  banks,  by  their  American 
correspondents.1 

§4 

How  and  Why  the  Bank  Discount  Rate  Affects  the  Price  of 
Demand  Drafts  and  the  Flow  of  Specie 

Changes  in  the  relative  rates  of  interest  in  different 
countries  affect,  temporarily,  rates  of  exchange  and  the 
flow  of  specie;  though  such  changes  in  relative  rates 

i  See  Ch.  Ill  (of  Part  I),  §  8. 


i34  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

of  interest  do  not  permanently  affect  the  international 
distribution  of  specie,  independently  of  comparative  price 
levels.  For  example,  much  is  said  of  the  influence  on 
the  rate  of  exchange  and  on  the  flow  of  gold,  of  the  Bank 
of  England  discount  rate.  If  the  Bank  of  England, 
because  of  too  rapidly  expanding  loans  or  because  of 
depletion  of  reserves,  raises  its  rate  of  discount,  being 
followed  in  this  move  by  the  other  English  banks,  its 
doing  so  has  a  tendency  to  lower  the  rate  of  exchange 
in  England  on  the  United  States  and  other  countries, 
and  to  raise  the  rate  in  the  United  States  and  elsewhere 
on  England.  It  has  this  effect  because  the  increased 
interest  in  England  tempts  to  investment  there  rather 
than  in  the  United  States.  English  banks  are  more 
likely  to  invest  current  funds  at  home,  and  may  even  draw 
on  debtor  banks  in  the  United  States  and  other  countries. 
American  and  other  banks  may  be  tempted  to  make 
short  term  loans  in  England  or  to  hold  or  have  held  until 
maturity,  long  bills  which  they  would  otherwise  have 
immediately  discounted.  This  holding  of  drafts  until 
maturity  will  compel  them  to  buy  more  drafts  on  Eng- 
land than  otherwise  would  be  necessary,  in  order  to 
maintain  their  usual  balances.  The  general  result  of  a 
high  discount  rate  in  England  is,  therefore,  a  high  rate 
of  exchange  on  and  a  flow  of  gold  to  England.1  Similarly, 
a  sharp  rise  in  the  discount  rate  in  New  York  would  tend 
to  produce  elsewhere  a  high  rate  of  exchange  on  New 
York,  and  would  tend  to  cause  a  flow  of  gold  to  New 
York. 

But  we  have  seen  that  the  flow  of  gold  from  country  to 
country  is  determined  by  comparative  prices  of  goods. 
If,  because  of  a  high  discount  rate  in  England,  gold  flows 

1  Goschen,  The  Theory  of  the  Foreign  Exchanges,  third  edition,  pp.  129-140. 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    135 

to  England  in  large  quantities,  so  that  prices  rise  there 
and  fall  here ;  then  England  becomes  a  good  place  to 
sell  to,  and  the  United  States  (and  other  countries)  by 
comparison  a  good  place  to  buy  from.  The  gold  will 
therefore  flow  back  for  goods  until  prices  are,  relatively, 
what  they  were  before.  Americans,  or  American  banks, 
who.  have  invested  in  England  because  of  the  high  rates 
of  interest  there,  will  have  invested,  in  fact,  not  money 
but  other  capital. 

But  at  this  point  a  qualification  must  be  made,  based 
on  the  fact  that  the  bank  rate  of  discount  influences,  in- 
directly, the  prices  of  goods.  The  bank  discount  rate  in- 
fluences prices  by  affecting  credit.  It  was  pointed  out,  in 
Chapter  II  (of  Part  I),1  that  the  general  level  of  prices  in 
a  modern  industrial  and  commercial  community  or  coun- 
try is  determined  not  alone  by  the  quantity  of  money  and 
its  velocity  of  circulation  and  by  the  volume  of  trade,  but 
also  by  the  amount  and  velocity  of  bank  credit.  The 
relationship  set  forth  was  expressed  in  the  equation, 

MV  +  M'V  =  pq  +  p'q'  +  etc. 

/ 

Ordinarily,  it  was  shown,  M'  maintains  a  fairly  constant 
rather  than  a  violently  fluctuating  ratio  to  M.  The 
total  amount  of  this  M '  or  bank  credit  in  a  community 
will  depend  partly  on  the  business  needs  and  customs 
of  that  community,  but  partly,  also,  on  the  quantity  of 
such  credit  which  the  banks  can  safely  keep  in  circula- 
tion with  a  given  support  of  cash  reserves.  If  lack  of 
confidence  depletes  these  reserves,  or  if  banks  have 
expanded  their  credit  too  far  for  their  reserves  safely  to 
support,  contraction  of  this  credit  is  necessary.  The 
banks  discourage  borrowing,  and  so  decrease  the  amount 


*36  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

of  circulating  bank  credit  by  charging  higher  interest 
to  borrowers,  i.e.  by  raising  their  rates  of  discount. 

Suppose,  then,  that  because  of  a  condition  of  business 
distrust  and  comparatively  small  reserves,  the  Bank  of 
England  and  other  English  banks  raise  their  rates  of 
discount.  As  a  consequence,  there  is  a  fall  in  the  rate 
of  exchange  on  New  York,  and,  in  New  York,  a  rise 
in  the  rate  on  London.  There  follows  a  flow  of  gold  to 
London  and  the  bank  reserves  there  are  replenished. 
But  this  gold  does  not,  at  least  for  the  time  being,  raise 
English  prices  and  result  in  a  corresponding  flow  of  gold 
back  to  the  United  States  (and  other  countries) ;  for 
the  increase  of  the  bank  charges  on  loans  discourages 
borrowing  from  banks,  and  so  tends  to  decrease  M' . 
In  the  equation,  MV  +  M'V  =  pq  +  p'q'  +  etc.,  for 
England,  the  />'s  may  not  be  at  all  increased  or  may  even 
be  decreased.1  Only  when  bank  credit,  in  England,  is 
again  allowed  to  expand,  will  the  full  effect  of  the  inflow 
of  gold  be  felt  in  higher  prices.  So  long  as  high  discount 
rates  keep  the  total  of  circulating  bank  credit  in  England 
less  than  before  in  relation  to  money,  the  inflow  of  gold 
does  not  so  much  raise  prices  as  substitute  itself  for  bank 
credit.  Hence,  gold  will  not  flow  out  again,  for  goods.2 

1  Cf.  Goschen,  The  Theory  of  the  Foreign  Exchanges,  p.  129,  where  this  idea, 
though  not  developed,  seems  to  be  implied. 

2  Just  before  the  outbreak  of  the  European  war  now   (August,   1914)    in 
progress,  the  efforts  of  European  investors  to  dispose  of  securities  for  gold  and 
the  closing  of  the  principal  bourses  of  the  world,  caused  a  flood  of  sales  on  the 
New  York  stock  exchange,  large  purchases  of  these  securities  by  Americans,  and 
an  unusually  strong  tendency  for  gold  to  flow  abroad.      In  view  of  the  sudden- 
ness and  violence  of  the  movement,  it  was  perhaps  not  unwise  that  the  New 
York  stock  exchange  should  be  temporarily   closed    (see  New   York  World, 
August  i,  1914)  and  that  the  sale  of  securities  here  by  foreigners  should  thus 
be  made  difficult.      It  is  true  that  the  flow  of  gold  abroad  (and  we  are  not  here 
concerned  with  any  other  reason  for  the  closing  of  the  exchange)  is  not  ordinarily 
a  proper  cause  for  alarm,  can  be  checked  by  a  rise  in  bank  discount  rates  if  such 
a  check  is  necessary,  and  will  in  any  case,  if  long  continued,  give  rise  to  a  re- 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    137 

§5 

Effect  of  a  Panic  in  One  Country  on  Conditions  in  Other 
Countries 

Since  prices  and  interest  rates  in  different  countries 
are  related,  a  panic  in  one  country  cannot  usually  be 
altogether  without  effect  on  other  countries  having  close 
commercial  relations  with  it,1  though  these  other  coun- 
tries may  not  be  affected  acutely.  When,  for  any  reason, 
in  a  country  of  large  commercial  importance,  business 
confidence  gives  place  to  acute  distrust,  and  the  banks, 
with  reserves  depleted  or  fearing  that  the  reserves  will  be 
depleted,  raise  their  discount  rates,  their  action  will 
affect  discount  rates  in  commercially  related  countries. 
The  strain  on  the  bank  reserves  of  the  first  country,  and 
the  rise  of  the  discount  or  interest  rate,  tends  to  draw 
gold  from  other  countries. 

This  will  tend  to  deplete  the  bank  reserves  of  those 
countries  in  relation  to  circulating  bank  credit.  Either 
the  gold  will  come  directly  from  these  bank  reserves  as 
when  it  is  drawn  from  the  great  central  banks  of  Europe 
for  export,  or  it  will  come  indirectly  but  just  as  surely 
from  bank  reserves,  as  when  gold  is  bought  for  export 
from  a  United  States  sub  treasury  and  is  paid  for  by 
lawful  money  which  might  otherwise  be  used  as  reserves.2 

turn  flow.  Yet  so  unprecedented  a  movement  as  the  recent  one  here  under 
discussion,  might  conceivably,  if  met  only  by  a  rise  in  the  discount  rate  (which 
would  also  have  to  be  great  and  sudden),  dangerously  and,  considering  the 
probable  temporary  nature  of  the  crisis,  unnecessarily  disturb  credit  conditions. 

1  Cf.  Fisher,  The  Purchasing  Power  of  Money,  New  York  (Macmillan),  1911, 
p.  267. 

1  Even  if  the  gold  is  purchased  with  bank  credit,  the  reserves  become  smaller 
in  proportion  as  compared  with  the  total  amount  of  such  credit ;  and  they  tend 
(since,  as  we  have  seen  —  Ch.  II,  §  5  —  business  men  keep  some  relation  between 
their  bank  accounts  and  cash  assets,  and  will  draw  out  cash  if  the  latter  become 
relatively  too  small)  to  become  absolutely  smaller. 


138  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

The  conclusion  is  that  in  any  case  the  banks  in  those 
countries  from  which  the  gold  is  drawn,  will  also  have 
occasion  to  raise,  somewhat,  their  discount  rates,  in  order 
to  keep  their  reserves  and  their  deposits  (and  notes) 
in  proper  relation  to  each  other.  And  if  contraction  of 
credit  causes  a  fall  of  prices  in  one  country,  the  mitigated 
effect  of  this,  at  least,  must  spread  to  other  countries. 
It  does  not  follow  that  a  severe  panic  in  one  country 
must  be  accompanied  by  or  succeeded  by  a  correspond- 
ingly severe  panic  in  others ;  but  only  that  in  each  of 
a  group  of  commercially  related  countries  there  will 
be  practically  simultaneous  rises  in  price  levels,  nearly 
simultaneous  high  prices  and  high  discount  (interest) 
rates,  and  substantially  simultaneous  decline.  The 
goodness  of  its  banking  system  (and  other  facts),  may 
make  the  changes  more  gradual  and  less  severe  in  one 
country  than  in  others,  but  is  not  likely  to  prevent  the 
changes  altogether. 

§6 

Exchange  between  Two  Countries  when  One  has  a  Gold 
and  the  Other  a  Silver  Standard 

An  excess  production  of  gold  in  any  country  raises 
prices  there  compared  to  prices  in  other  countries, 
encourages  buying  goods  in  other  countries,  and  there- 
fore raises  the  rate  of  exchange  on  other  countries. 
Export  of  gold  follows.  The  introduction  of  a  cheaper 
standard  of  value  has  the  same  effect.  A  large  coinage 
of  cheaper  money,  e.g.  silver  at  a  ratio  of  16  to  i  (which 
would  greatly  overvalue  silver  and  lead  to  a  large  coin- 
age), would  increase  M.  Prices  would  rise  and  the  value 
of  money  would  fall.  Goods  would  therefore  be  pur- 
chased abroad.  The  rate  of  exchange  on  foreign  coun- 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    139 

tries  would  rise  and  gold  would  be  exported.  As  long 
as  the  silver  and  gold  both  circulated  and  were  generally 
acceptable  for  goods  at  the  legal  ratio,  the  rate  of  ex- 
change would  not  rise  much  above  the  gold  export 
point.  But  if  this  ratio  encouraged  the  continued  coin- 
age of  silver,  the  gold  would  eventually  be  entirely 
driven  out  of  the  currency  of  the  silver  coining  country. 
Then  the  rate  of  exchange  would  rise  even  higher,  for 
prices  in  the  silver  country  would  continue  to  rise  until 
silver  coin  had  no  greater  value  than  silver  bullion.  But 
once  the  gold  had  been  entirely  driven  out,  there  could 
be  no  further  effect  on  the  amount  of  money  and  there- 
fore on  prices,  in  other  countries,1  produced  by  the  coin- 
age of  silver.  Consequently,  the  prices  of  the  silver 
country  would  be  permanently  higher  than  formerly, 
compared  to  prices  abroad,  and  its  money  standard  of 
less  value.  Instead  of  the  rate  of  exchange  on  England, 
supposing  the  United  States  to  be  the  silver  standard 
country,  averaging  $486.65  =  £100,  it  might  average 
$973-3°  =  £100,  or  some  other  new  and  higher  rate. 
The  rate  of  exchange  would  have  risen  tremendously. 
In  fact,  such  a  rise  in  the  rate  of  exchange  is  good  evi- 
dence of  a  cheaper  or  depreciated  currency.  But  the 
rate  of  exchange,  though  in  figures  much  higher  than 
before,  would  not  necessarily  be  above  par.  Instead, 
there  would  be  a  new  par.  $973.30  =  £100  might  have 
become  this  par.  Exchange  would  thereafter  fluctuate 
about  this  new  instead  of  about  the  old  and  lower  par. 

Par  of  exchange  would  no  longer  be  steady.  For  with 
one  country  on  a  silver  standard  and  the  other  on  a  gold 
standard,  the  monetary  unit  of  one,  e.g.  the  dollar,  would 
have  no  fixed  relation  to  the  monetary  unit  of  the  other, 

*See,  however,  remainder  of  this  section  (6). 


140  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

e.g.  the  pound.  The  value  ratio  of  these  units  would 
vary  with  the  value  ratio  in  the  bullion  markets,  of  sil- 
ver and  gold.  But  exchange  in  neither  country,  on  the 
other,  could  go  above  par  by  much  more  than  the  cost 
of  shipping  specie.  Exchange  in  the  silver  standard 
country  on  the  gold  standard  country,  would  be  limited 
by  the  cost  of  gold  in  terms  of  silver,  plus  the  cost  of 
shipment.1  Vice  versa,  exchange  in  the  gold  country  on 
the  silver  country,  could  not  go  higher  than  the  cost  of 
silver  in  terms  of  gold,  plus  the  cost  of  shipment. 

How  would  trade  balance  when  there  was  no  longer, 
between  two  such  trading  countries,  the  influence  of  price 
relations  in  the  same  precious  metal,  to  make  the  flow 
of  goods  one  way  balance  a  return  flow  ?  The  balance 
might  then  be  brought  about  by  the  flow  of  gold  one  way, 
and  of  silver  the  other.  If  we  should  for  a  time  buy  more 
in  England  than  the  English  of  us,  and  had  a  net  indebted- 
ness to  meet,  we  might  purchase  gold  in  the  bullion 
market  here,  with  which  to  settle.  This  (assuming  the 
United  States  to  be  on  a  silver  standard)  would  not 
directly  affect  our  prices,  but  would  increase  the  quantity 
of  money  and  tend  to  raise  prices  in  England.  In  this 
country  it  would  tend  to  make  gold  bullion  scarce  and  dear 
as  compared  with  our  silver  money  and  with  other  goods. 
A  given  amount  of  English  money  would  buy  more 
American  dollars  than  before,  and  wpuld  buy  more 
American  goods  than  before,  as  compared  with  the  goods 
it  would  buy  in  England.  That  is,  par  of  exchange  in 
England  on  the  United  States  would  be  lower.  There 
would  also,  of  course,  be  some  tendency  for  prices  in  one 
country  to  fall  and  in  the  other  to  rise  because  of  the  flow 

1  Goschen,  The  Theory  of  the  Foreign  Exchanges,  pp.  76-81 ;  cf.  Clare,  The 
A.B.C.  of  the  Foreign  Exchanges,  London  (Macmillan),  1893,  pp.  139-142.  • 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    141 

of  goods  as  well  as  because  of  the  flow  of  money.  The 
greater  supply  of  goods  in  the  importing  country,  the 
United  States,  in  relation  to  money,  would  tend  to  lower 
the  price  level;  while  the  outflow  of  goods  from  the 
exporting  country,  England,  would  tend,  there,  to  raise 
the  price  level. 

The  fact  that  a  given  amount  of  English  money  would 
buy  more  American  goods  than  before,  would  encourage 
English  buying  here ;  while  the  less  purchasing  power 
over  English  goods,  of  American  money,  would  dis- 
courage American  buying  in  England.1  Hence  trade 
would  reach  equilibrium  or  would  flow,  for  a  time,  in  the 
opposite  direction.2  Exchange  in  England  on  the  United 
States  would  rise  above  par,  and  specie  would  be  shipped. 

If  exchange  on  England  should  be  below  par  and  the 
flow  of  specie  should  be  from  them  to  us,  the  same  prin- 
ciple would  apply.  The  silver  sent  to  us  in  settlement 
of  balances  would  tend  to  raise  our  prices  and  lower 
the  value  of  silver  in  the  United  States.  Its  exportation 
from  England  would  tend  to  make  silver  in  England 
relatively  scarce  and  dear.  As  a  consequence,  a  given 
number  of  American  dollars  would  buy  more  pounds  than 
before  and  would  buy  more  goods  in  England  than 

1  Cf.  Bastable,  The  Theory  of  International  Trade,  fourth  edition,  London 
(Macmillan),  1903,  pp.  59,  60.     See  also  Professor  Marshall's  "memorandum" 
on  the  effect  in  international  trade  of  different  currencies,  Appendix  to  Final 
Report  of  the  Gold  and  Silver  Commission,  1888,  pp.  47-53. 

2  If  we  suppose  American  silver  exported  to  buy  English  gold  for  settling 
the  balance  against  us,  because  of  a  more  favorable  price  of  gold  in  England  com- 
pared to  silver,  we  shall  nevertheless  reach  the  same  final  conclusion.     On  this 
supposition,  the  outflow  of  silver  would  tend  to  lower  American  prices,  raising 
here  the  value  of  silver.     In  England,  silver  would  become  of  less  value  in  com- 
parison with  gold.     A  given  sum  of  English  money  would  buy  more  American 
money,  and  would  buy  more  American  goods  than  before  as  compared  with  the 
goods  it  would  buy  in  England.    Therefore,  the  flow  of  trade  must  reach  equilib- 
rium or  even  be  temporarily  reversed. 


i42  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

before  as  compared  to  what  they  would  buy  here.  The 
surplus  flow  of  goods  from  the  United  States  to  England 
would,  other  things  equal,  be  brought  to  an  end.  If, 
therefore,  two  trading  countries  have,  respectively,  a 
silver  and  a  gold  standard,  the  laws  of  trade  between  them 
are  not  greatly  different  than  if  both  have  the  same 
standard.  It  is  still  true  that  each  will  buy  goods  of  the 
other ;  and  it  is  still  true  that  an  excess  flow  of  trade  in 
one  direction  tends  so  to  change  monetary  and  price 
conditions  as  to  bring  its  own  termination. 

§7 

Exchange  between  Two  Countries  when  One  has  a  Gold 
and  the  Other  an  Inconvertible  Paper  Standard 

Let  us  now  suppose  the  case  of  a  paper  standard,  i.e. 
paper  money  not  redeemable  in  specie,  in  one  of  two 
trading  countries,  and  a  gold  standard  in  the  other,  as 
with  the  United  States  and  England  during  our  Civil 
War  period.  The  rate  of  exchange  in  the  paper  money 
country  on  the  other,  would  depend  chiefly  on  the  cost 
of  gold  in  terms  of  paper,  and  therefore  would  rise  as  the 
paper  money  depreciated  in  relation  to  gold.1  Thus, 
during  the  Civil  War,  exchange  in  the  United  States  on 
other  countries,  e.g.  England,  rose  to  a  very  high  figure, 
because  of  the  depreciation  of  the  greenbacks.  Con- 
versely, the  rate  of  exchange  in  the  gold  standard  country 
on  the  country  with  a  paper  standard  would  depend 
mainly  on  the  cost  of  this  paper  money  in  terms  of  gold, 
and  therefore  would  fall  as  the  paper  money  depreciated.2 
In  the  paper  money  country,  the  upper  limit  of  exchange 
on  the  other  cannot  much  exceed  the  cost  of  purchasing 

1  Goschen,  The  Theory  of  the  Foreign  Exchanges,  pp.  69,  70.  *  Ibid. 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    143 

gold  with  paper,  plus  the  cost  of  shipping  the  gold.1 
If  we  regard  exchange  between  two  such  countries  as  at 
par  (though  the  paper  money  might  be  depreciated  far 
below  par)  when  the  money  of  the  paper  standard  coun- 
try will  buy  just  as  much  exchange  on  the  gold  standard 
country  as  it  will  buy  gold  at  home,2  then  we  may  say 
that  exchange  could  rise  above  par  by  the  cost  of  shipping 
specie.3  In  general,  we  may  say  that  exchange  might 
either  rise  above  or  fall  below  this  par,  by  the  cost  of 
specie  shipment,  just  as  it  might  rise  above  or  fall  below 
par  by  the  cost  of  specie  shipment  if  both  countries  had 
the  same  specie  as  standard. 
When  one  of  two  countries  has  inconvertible  paper  and 

Ubid. 

'This  is  the  logical  though  not  the  ordinary  use  of  the  word  "par"  in  re- 
lation to  exchange,  when  one  country  has  a  depreciated  currency.  It  is  custom- 
ary to  regard  as  par  what  would  be  par  if  there  were  no  depreciation.  Strictly 
speaking,  however,  the  departure  from  this  rate,  due  to  depreciation,  means  a 
departure  of  the  money  from  par,  rather  than  of  exchange. 

8  This  is  not  inconsistent  with  Bastable's  statement  (Theory  of  International 
Trade,  pp.  87,  88)  regarding  the  possible  rise  of  the  exchanges  on  other  countries, 
in  a  country  having  an  inconvertible  but  not  depreciated  paper  money.  In 
such  a  case,  it  is  said,  if  a  sudden  demand  for  exchange  and,  consequently,  for 
gold  to  export,  is  coincident,  in  the  paper  money  country,  with  a  temporarily 
inadequate  supply  of  gold,  exchange  may  rise  above  the  usual  specie  shipping 
point.  But  though  the  rate  may  go  up  beyond  the  usual  shipping  point,  it  can 
hardly  be  said  to  do  so  if  the  paper  money  is  in  no  sense  depreciated.  Though 
the  paper  money  may  not  have  depreciated  in  relation  to  goods  in  general, 
and  may  not  have  depreciated,  permanently,  in  relation  to  gold,  yet,  for  the  time 
being,  it  has  depreciated  compared  to  gold  in  the  paper  standard  country.  Under 
such  circumstances,  however,  it  may  fairly  be  emphasized  that  the  rise  of  ex- 
change is  due  rather  to  a  local  rise  in  the  value  of  gold  than  to  a  fall  in  that  of 
the  paper. 

A  special  case  discussed  by  Goschen  (The  Theory  of  the  Foreign  Exchanges, 
pp.  70-72),  is  that  of  a  country  which,  having  an  inconvertible  paper  money, 
has  also  forbidden  the  export  of  the  precious  metals.  In  such  a  country,  exchange 
on  others  cannot  be  prevented,  by  shipment  of  specie,  from  rising  above  the 
gold  shipping  point,  since  the  law  forbids  such  shipment.  Except  as  the  law 
may  be  evaded,  a  rising  exchange  rate  can  then  only  be  limited  by  a  retardation 
of  imports  and  a  stimulation  of  exports  (see  §  9  of  this  chapter)  or,  for  a  time,  by 
borrowing  from  abroad  (see  Goschen,  Foreign  Exchanges,  loc.  cit.). 


144  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

the  other  a  gold  standard,  the  effect  on  prices,  produced 
by  the  flow  of  specie  consequent  on  trade  between  them, 
could  occur  only  in  the  gold  standard  country.  When 
the  paper  standard  country  has  a  balance  to  pay,  gold 
may  be  purchased  with  this  paper  money  and  exported 
(or,  which  for  purposes  of  our  discussion  amounts  to  the 
same  thing,  imported  by  the  gold  standard  country). 
This  will  raise  prices  in  the  gold  standard  country  to 
which  the  gold  flows.  If  the  trade,  however,  is  between 
a  paper  standard  country  and  several  gold  standard 
countries,  the  effect  on  the  latter  will  be  more  diffused 
and  their  prices  raised  but  slightly.  But  the  outflow 
of  gold  bullion  from  the  paper  standard  country  will 
tend,  if  long  continued,  to  make  gold  in  that  country 
scarce  and  dear  in  relation  to  other  desired  goods.  A 
given  amount  of  gold  will  buy  not  only  more  paper 
money,  but  also  more  of  other  goods  than  before.  Drafts 
drawn  on  the  gold  standard  country,  or  remitted  by  its 
people,  in  payment  for  goods  purchased  in  the  paper 
standard  country,  will  represent  less  gold  than  previously 
for  the  same  goods  bought.  Therefore,  more  goods 
will  be  purchased  in  the  paper  standard  country  by  the 
people  of  the  other,  and  gold  will  flow  back  again  to 
the  former  country.  This  tendency  is  accentuated  by  the 
flow  of  goods.  If,  at  first,  goods  are  imported  by  the 
paper  standard  country,  the  larger  supply  of  goods  in  that 
country,  relative  to  the  paper  money  and  to  gold,  tends 
to  make  the  prices  of  these  goods  lower  in  either  standard. 
In  the  exporting  country,  relative  scarcity  of  goods  tends 
to  make  prices  somewhat  higher  measured  in  gold. 
Hence,  for  this  reason  also,  more  goods  are  bought  with 
gold  in  the  paper  standard  country,  and  gold  tends  to 
flow  to  that  country. 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    145 

§8 

Exchange  between  Two   Countries  when  Both  have  In- 
convertible Paper  Standards 

Suppose,  next,  that  there  is  in  each  of  two  trading 
countries  an  inconvertible  paper  standard.  Then  the 
rate  of  exchange  in  either  upon  the  other,  so  long  as  gold 
is  the  medium  for  settling  international  balances,  will 
depend  on  the  value  of  both  currencies  in  relation  to  gold. 
Suppose  the  two  countries  to  be  the  United  States  and 
France.  Then,  in  the  United  States,  exchange  on  France 
would  rise  if  American  money  depreciated  compared 
to  gold  (French  money  remaining  the  same) ,  or  if  French 
money  appreciated  in  relation  to  gold  (American  money 
remaining  the  same),  or  if,  simultaneously,  American 
money  depreciated  and  French  money  appreciated.  The 
same  causes  would  make  exchange  in  France  on  the 
United  States  fall.  The  rise  in  exchange  on  France 
and  the  fall  in  exchange  on  the  United  States  would  be 
limited  by  the  depreciation  of  the  American  money 
plus  the  appreciation  of  the  French  money,  plus  the  cost 
of  specie  shipment.  For  if  American  money  depreciated 
one-half  compared  to  gold,  exchange  on  France  (excluding 
the  cost  of  gold  shipment)  would  double,  since  it  would 
take  twice  as  many  American  dollars  to  buy  the  same 
amount  of  gold  for  shipment  to  France,  and,  therefore, 
to  buy  the  gold  equivalent  of  a  certain  number  of  francs. 
Likewise,  if  French  money  doubled  in  value  in  relation 
to  gold,  exchange  on  France  would  double,  since  it  would 
take  twice  as  many  dollars  as  before  to  buy  the  double 
amount  of  gold  which  was  now  the  equivalent  of  a  given 
number  of  the  doubled  value  francs.  Above  this 
amount,  exchange  could  rise  by  the  cost  of  shipping  gold. 


146  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

Under  the  assumed  circumstances,  the  currencies  of 
the  two  countries  would  be  unrelated  to  each  other.  No 
amount  of  buying  by  the  merchants  of  the  United  States, 
in  France  could,  through  a  flow  of  money,  lower  Ameri- 
can or  raise  French  prices,  for  American  money  would 
not  be  legal  tender  in  France  or  (being  paper)  of  any 
intrinsic  value  there.  Neither  could  French  buying  in 
the  United  States  produce,  by  the  flow  of  money,  the 
reverse  consequence.  How,  then,  would  excess  buying 
by  one  country  in  the  other  eventually  cause  more 
buying  by  the  second  in  the  first  ?  It  would  have  this 
effect  through  the  flow  of  gold  and  the  consequent  influ- 
ence on  the  value  of  gold  in  the  two  countries ;  and  also 
through  the  flow  of  goods  and  the  effect  of  that  flow  on 
prices  in  the  two  countries  and  so  on  the  relative  values 
of  gold,  in  both  countries,  in  relation  to  goods. 

If  the  United  States  should  buy  more  of  France  in  any 
period  than  it  sold  to  France,  gold  would  flow  to  France. 
Gold  would  therefore  come  to  have  more  value  in  the 
United  States,  where  it  was  scarce,  and  less  value  in 
France,  than  before.  A  given  number  of  francs  would  buy 
more  gold,  and  a  given  amount  of  gold  would  buy  more 
dollars.  Par  of  exchange,  in  the  sense  here  used,  would 
be  lower  in  France  on  the  United  States,  and  higher  in 
the  United  States  on  France.  This  means  that  in  terms 
of  French  money,  goods  could  be  purchased  in  the  United 
States  more  cheaply  than  before;  while  in  terms  of 
American  money,  French  goods  would  be  more  expensive 
than  before.  As  a  consequence,  the  French  would  buy 
more  American  goods,  and  Americans  would  buy  less 
French  goods;  the  rate  of  exchange  in  France  on  the 
United  States  would  rise  above  this  low  par,  and  in  the 
United  States  on  France  it  would  fall ;  and  gold  would 
flow  back  from  France  to  the  United  States. 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    147 

In  addition,  if  the  United  States  should  buy  a  net 
balance  of  goods  from  France,  in  any  period,  this  would 
tend  to  make  goods  more  plentiful  in  the  United  States 
and  less  so  in  France,  in  relation  to  gold,  so  that,  for  this 
reason  also,  it  would  become  more  profitable  than  before 
to  send  gold  from  France  to  the  United  States  for  goods. 

§9 

Exchange   between    Two  Countries,   Assuming  Effective 
Prohibition  of  Specie  Shipment 

So  far  we  have  assumed,  even  when  discussing  trade 
between  countries  having  unrelated  currencies,  that  gold 
or  silver  would  be  used  to  settle  international  balances. 
But  suppose  that  the  mediaeval  theory  of  prohibiting 
the  export  of  specie  were  still  in  vogue  and  were  com- 
monly applied.  Would  there  be,  then,  any  limits  to  the 
fluctuations  of  exchange  (assuming  obligations  still  to 
be  settled  by  using  drafts),  and  would  there  still  be  a 
tendency  for  the  trade  in  opposite  directions,  to  balance  ? 
Under  usual  existing  conditions,  the  fluctuations  of  ex- 
change with  any  country  are  limited,  as  we  have  seen, 
by  the  cost  of  shipping  specie.  Any  further  rise  or  fall 
is  checked  by  specie  shipment  and  by  the  consequent 
effect  on  supply  of  drafts,  or  demand  for  them,  or  both. 
But  if  specie  shipment  were  prohibited,  and  prohibited 
at  all  effectively,  the  limits  to  exchange  fluctuations  could 
not  be  so  narrow.  The  rate  of  exchange,  for  example, 
in  the  United  States  on  England,  if  the  balance  of  obliga- 
tions were  markedly  in  England's  favor,  could  then  go 
considerably  above  $488.65  without  at  once  increasing 
the  supply  of  or  decreasing  the  demand  for  drafts  on 
England,  to  such  an  extent  as  to  stop  the  rise.  Since 


148  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

gold  could  not  be  exported,  Americans  owing  money  in 
England  would  have  to  settle  by  remitting  drafts  or  by 
redeeming  drafts  drawn  against  them.1  In  the  latter 
case,  American  banks  must  purchase  drafts  on  England 
in  order  to  settle  with  correspondents,  since  the  alterna- 
tive of  shipping  specie  is  excluded.  Drafts  on  England 
might,  therefore,  sell  at  a  rate  which  American  debtors 
and  debtor  banks  would  refuse  to  pay  if  they  had  the 
forbidden  alternative. 

Yet  there  would  still  be  limits,  though  wider  and 
perhaps  less  definite  ones,  to  the  fluctuations  in  the  price 
of  drafts.  The  high  price  of  drafts  on  England  would 
encourage  and  stimulate  the  sale  of  American  goods  in 
England  and  would  discourage  buying  goods  from  Eng- 
land. Goods  which  would  bring,  in  England,  say  £100, 
but  which  would  not  ordinarily  be  sent  there  for  sale, 
because  that  sum  yielded  no  profit,  might  be  exported  if 
a  draft  on  England  for  £100  would  sell,  here,  for  $495. 
And  the  sale  of  goods  in  England,  thus  stimulated,  would 
tend,  by  increasing  the  supply  of  drafts  on  England,  to 
prevent  further  rise  in  the  prices  of  such  drafts.  Also, 
goods  which  could  be  purchased  in  England  for  $100 
and  which,  if  $486.65  would  buy  a  draft  for  £100  and 
so  would  pay  for  the  goods,  would  be  bought  in  England, 
very  probably  would  not  be  bought  if  the  draft  necessary 
to  pay  for  them  cost  $495. 

Conversely,  even  though  exchange  on  England  fell 
below  the  gold  shipping  point,  because  of  a  net  balance 
owing  from  England  to  us,  combined  with  an  English 
prohibition  on  the  outflow  of  gold  from  England,  such  a 
fall  in  exchange  would  not  be  without  limit.  For  it 

1  Renewal  of  credit,  use  of  finance  bills,  etc.,  would  of  course  serve  as  tempo- 
rary expedients  to  postpone  settlement. 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    149 

would  encourage  buying  in  England.  Goods  priced 
in  England  at  £100  and  which  otherwise  it  would  not 
pay  to  buy  there,  might  be  bought  if  a  sight  draft  on 
London  for  £100  could  be  obtained  here  for  (say)  $478. 
And  such  purchase  of  goods,  by  creating  a  larger  demand 
for  drafts  on  England,  would  tend  to  prevent  further  fall 
in  the  prices  of  these  drafts. 

When  balances  are  habitually  settled  by  the  shipment 
of  gold  (or  other  precious  metals),  as  in  modern  trade, 
the  limits  of  fluctuation  in  exchange  are  narrow  because 
gold,  having  large  value  in  small  bulk,  can  be  shipped 
for  a  small  per  cent  of  its  value.  An  excess  of  trade 
in  one  direction,  therefore,  acts  largely  through  a  flow 
of  gold  as  an  intermediate  cause,  in  bringing  about  a 
balancing  flow  of  trade  in  the  contrary  direction.  This 
flow  of  gold  affects  prices  in  both  countries,  if  both  have 
the  gold  standard.  In  any  case,  it  affects  the  relative 
purchasing  power  of  gold  in  these  countries,  and  the 
amount  of  goods  that  the  currency  of  the  one,  by  being 
first  exchanged  for  gold,  will  buy  in  the  other,  compared 
to  what  it  will  buy  at  home.  There  follows,  as  a  result 
of  this  change  in  relative  prices  or  in  relative  values  of  the 
two  money  standards,  a  change  in  the  flow  of  trade. 
This  change  in  the  flow  of  trade  is,  therefore,  in  large 
part,  but  an  indirect  consequence,  through  the  flow  of 
gold,  of  a  rising  or  falling  rate  of  exchange.  But  if  the 
flow  of  specie  were  effectively  prohibited,  and  the  fluc- 
tuations in  exchange  were,  in  consequence,  greater 
(assuming  drafts  to  be  still  used  as  the  chief  means  of 
settling  obligations  between  countries),  the  high  and  low 
prices  of  drafts  would  act  with  greater  force  directly  on 
the  flow  of  trade. 

It  should  be  emphasized  that  high  and  low  exchange 


150  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

have  always,  to  some  extent,  this  direct  influence.  If  a 
draft  on  England  for  £100  will  sell  for  $488  in  New  York, 
it  may  be  profitable  to  export  goods  to  England  which  it 
would  not  pay  to  export  if  exchange  were  low.  Simi- 
larly, if  drafts  on  England  for  £100  can  be  secured  for 
$484.70,  it  may  be  worth  while  to  buy  goods  there  which, 
if  exchange  were  higher,  would  not  be  purchased.  A  flow 
of  trade  in  one  direction  has  always,  then,  some  slight 
tendency  to  bring  about  its  own  termination  through 
affecting  the  rate  of  exchange,  and  thereby  the  direction 
of  trade.1  But  this  more  direct  influence  would  be 
greater,  because  the  fluctuations  in  exchange  would  be 
greater,  if  specie  could  not  be  exported  from  either  of 
two  trading  countries.  Our  conclusion  is  that  whatever 
the  relation  of  the  currencies  of  two  trading  countries, 
and  whatever  the  mechanism  of  settling  balances,  or 
whatever  the  restrictions  on  settlement  by  the  use  of  any 
special  commodity,  e.g.  gold,  an  excess  flow  of  trade  in 
one  direction  introduces  always  a  tendency  towards  an 
opposite  and  balancing  flow. 

§  10 

The  Effect  on  the  Rate  of  Exchange  of  High  Import  and 
Export  Duties 

Let  us  now  give  very  brief  consideration  to  the  effects 
on  exchange  of  high  import  duties,  e.g.  the  so-called 
protective  tariff.  The  protective  tariff  is  a  high  tax  on 
imports,  intentionally  made  so  high  as  to  prevent  or 
decrease  imports,  and  encourage  buying  at  home^ 
For  the  time  being,  the  country  adopting  such  a  policy 
will  export  an  excess,  the  rate  of  exchange  on  other  coun- 

iCf.  Ch.  V  (of  Part  I),  §6. 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    151 

tries  will  be  low,  and  specie  will  flow  in.  Then  prices 
rise  in  the  protectionist  country  in  relation  to  prices 
elsewhere,  exports  are  checked,  and  an  equilibrium  is 
reached  ;  and,  in  the  absence  of  other  disturbing  causes, 
exchange  will  again  average  par. 

On  the  other  hand,  the  first  effect  of  a  high  tariff  on 
exports  would  be  to  decrease  exports.  For  a  while 
imports  would  be  in  excess.  Therefore,  the  rate  of 
exchange  would  rise.  Eventually  specie  would  flow 
out,  prices  would  fall,  imports  and  exports  would 
again  balance  (other  disturbing  factors  absent),  and 
there  would  no  longer  be  the  tendency  caused  by  excess 
imports  for  the  fall  of  prices  to  continue. 


Summary 

In  this  chapter  the  attempt  has  been  made  to  bring 
together  various  considerations  regarding  exchange, 
which  seemed  to  have  no  proper  place  in  the  chapters 
preceding.  To  begin  with,  a  distinction  was  made 
between  sight  drafts  and  those  payable  some  time  after 
sight.  A  study  of  the  pure  rate  of  exchange  has  to  do 
only  with  the  former.  The  prices  of  the  latter  depend 
also  upon  the  rate  of  interest.  Two  possible  methods 
of  procedure  when  an  American  bank  invests,  for  the 
interest,  in  drafts  on  foreigners,  were  described.  It  was 
shown  that  the  prices  of  long  drafts  may  be  influenced 
by  the  rate  of  interest  in  the  drawing  and  in  the  accept- 
ing country.  If  the  rate  of  interest  in  the  accepting 
country  is  the  lower,  this  rate  determines  the  prices  of 
long  drafts  ;  but  if  the  rate  of  interest  in  the  drawing 
country  is  the  lower,  purchase  of  the  drafts  by  investors 


152  THE  EXCHANGE  MECHANISM  OF  COMMERCE 

or  investing  banks  in  that  country  may  make  these  drafts 
sell  for  somewhat  more  than  the  higher  rate  of  interest 
in  the  accepting  country  would  otherwise  allow. 

Consideration  was  given  to  the  influence  on  the  pure 
rate  of  exchange  and  on  the  flow  of  specie,  of  changes  in 
interest  or  discount  rates  in  different  countries.  It  was 
seen  that  a  rise  of  the  bank  discount  rate  in  any  country 
tends  to  create,  elsewhere,  high  rates  of  exchange  on  that 
country  and  a  flow  of  specie  to  it.  But  it  was  also  seen 
that  the  chief  effect  of  such  a  rise  in  bank  discount  is  to 
check  undue  credit  expansion  or  reduce  excessive  credit. 
Only  as  it  has  this  effect,  will  the  inflow  of  specie  be  pre- 
vented from  so  raising  prices  as  to  result  in  a  subsequent 
corresponding  outflow.  Since  interest  rates  and  prices 
in  different  countries  are  related,  it  follows  that  a  finan- 
cial panic  in  one  country  must  produce  some,  though  per- 
haps comparatively  mild,  effects  upon  other  countries. 

The  rates  of  exchange  between  countries  having  dif- 
ferent monetary  standards  were  next  considered.  If 
one  country  has  gold  and  another  silver,  exchange  can 
fluctuate  as  the  ratio  of  value  of  silver  to  gold  fluctuates, 
and,  in  addition,  by  the  cost  of  specie  shipment.  If  one 
country  has  gold  and  the  other  has  inconvertible  paper, 
exchange  in  the  latter  on  the  former  can  rise  (and  in  the 
former  on  the  latter,  fall)  by  the  amount  of  depreciation 
of  the  paper  in  terms  of  gold,  plus  the  cost  of  gold  ship- 
ment. If  both  countries  have  inconvertible  paper,  ex- 
change in  either  on  the  other  can  rise  by  the  amount  of 
depreciation  in  the  currency  of  the  first  plus  the  amount 
of  appreciation  in  that  of  the  second,  plus  the  cost  of 
specie  shipment.  Whatever  the  monetary  standard  or 
standards  of  trading  countries,  exchange  could  fluctuate 
beyond  the  above  assigned  limits,  if  the  movement  of 


FURTHER  CONSIDERATIONS  ON  EXCHANGE    153 

specie  were  to  be  effectively  prohibited.  But  whatever 
the  standard  or  standards,  it  appeared  that  trade  cannot 
flow  continuously  in  one  direction  without  introducing 
a  tendency  to  a  reverse  flow.  By  acting  on  relative 
price  levels,  or  on  relative  values  of  currency  in  relation 
to  gold,  or  only  on  rates  of  exchange,  the  surplus  flow  in 
one  direction  will  eventually  bring  itself  to  an  end. 

Lastly,  brief  attention  was  given  to  the  effects  on 
exchange,  of  import  and  export  duties.  The  former  make 
exchange  on  other  countries  temporarily  lower/  The 
latter  make  it  temporarily  higher.  In  the  former  case, 
equilibrium  is  reached,  after  an  inflow  of  specie,  with  a 
higher  level  of  prices  in  the  country  levying  the  duties. 
In  the  latter  case,  when,  after  an  outflow  of  specie,  equi- 
librium is  again  reached,  the  level  of  prices  in  the  duty- 
levying  country  is  lower. 


PART  II 
THE  ECONOMIC  ADVANTAGES  OF  COMMERCE 


CHAPTER  I 

PRICES,  INTERCOMMUNITY  TRADE,  AND  THE  GAINS  OF 

TRADE 

§i 
The  Relation  of  Prices  in  One  Country  to  Prices  in  Another 

THROUGH  the  influence  of  trade,  the  price  in  any 
country  of  any  special  kind  of  goods  tends  toward 
equality  with  the  price  of  the  same  goods  in  other  coun- 
tries with  which  the  first  one  trades.  Cost  of  carriage, 
of  course,  must  enter  into  the  selling  price  of  any  kind 
of  goods.  Due  to  the  natural  productivity  of  land, 
greater  efficiency  of  labor,  better  capital  equipment,  or 
other  cause,  some  goods  will  probably  be  produced  with 
less  relative  cost  in  one  country  than  in  the  others  trading 
with  it.  These  goods  will  tend  to  be  cheaper  in  the 
country  having  such  an  advantage,  and  to  be  sold  by  it 
to  the  others.  The  price  of  such  goods  in  the  other 
countries  cannot,  for  any  length  of  time,  be  higher  than 
in  the  exporting  country  by  much  more  than  the  expense 
of  transportation  or,  if  trade  is  restricted,  the  expense  of 
transportation  plus  tariff  charges ;  for  if  the  price  is  much 
higher,  none  of  the  goods  in  question  will  be  sold  in  the 
country  where  they  are  produced,  until  enough  has  been 
sent  abroad  to  more  nearly  equalizeprices.  Neither  can 
the  price  abroad  of  goods  produced  under  competitive 
conditions,  be  less  than  the  price  in  the  producing  country 


4       ECONOMIC  ADVANTAGES  OF  COMMERCE 

plus  cost  of  transportation  and  tariffs,  if  any  of  the  goods 
at  all  are  sent  abroad.1 

To  illustrate,  suppose  a  certain  kind  of  cloth  to  be 
selling  at  wholesale  in  England  for  (the  equivalent  in 
English  money  of)  $i  per  yard.  Assuming  a  transporta- 
tion and  tariff  expense  of  50  cents  a  yard,  it  would  sell 
in  Canada,  wholesale,  for  $1.50.  Suppose,  next,  that 
the  Canadian  demand  raised  the  Canadian  price  to 
$1.75  per  yard.  If  the  carrying  and  tariff  costs  remained 
at  50  cents,  and  the  Canadian  price  $1.75,  obviously  no 
one  would  sell  the  cloth  in  England  for  much  less  than 
$1.25.  If,  on  the  other  hand,  the  Canadian  demand 
should  decrease  so  that  the  cloth  could  not  be  sold 
in  Canada  for  more  than  $1.25,  then  none  of  this 
cloth  would  be  sent  from  England  to  Canada  unless 
the  English  price  fell  to  $0.75.  If,  because  the 
whole  supply  had  to  be  sold  in  England,  the  price 
should  fall  to  $0.75  per  yard,  a  surplus  might  be  ex- 
ported. Otherwise,  it  would  pay  better  to  sell  all  the 
cloth  in  England. 

It  will  be  seen  that  the  general  level  of  prices  in  one 
country  is  not  by  any  means  necessarily  the  same  as  the 
price  level  in  the  other  countries  with  which  it  trades. 
If  we  imagine  two  countries  side  by  side,  with  no  tariff 
barriers  between  them,  and  with  a  zero  cost  of  transpor- 
tation from  any  part  of  one  to  any  section  of  the  other, 
we  may  say  that  the  price  of  each  commodity  in  one 
country  must  equal,  measured  in  the  same  standard  of 
value,  its  price  in  the  other.  Obviously,  if  all  prices 

1  Except  as  goods  may  be  sold  cheaper  abroad  temporarily  In  order  to  de- 
velop new  business,  and  for  other  special  reasons  of  very  limited  application. 
A  tariff  protected  monopoly  will  purposely  limit  its  sales  at  home  in  order  to 
realize  monopoly  profits,  while  selling  abroad,  where  competition  must  be  met, 
at  competitive  prices. 


INTERCOMMUNITY  TRADE  5 

are  exactly  the  same,  then  the  general  average,  the  level 
of  prices,  must  be  exactly  the  same  in  one  country  as 
in  the  other.  In  comparing  the  price  levels  of  two 
countries,  we  may  take  as  a  unit  that  amount  of  each 
kind  of  goods,  in  one  of  the  countries,  which  sells  for  $i 
(or  £i  or  some  other  standard  monetary  unit).  The 
average  price  in  that  country  will  be  $i.  We  may  then 
learn  the  price  in  the  other  country,  of  each  such  unit 
amount  of  goods,  and  take  the  average  of  these  prices. 
This  gives  us  the  general  level  of  prices  in  the  second 
country  as  compared  with  that  of  the  first.1  The  most 
satisfactory  average  is,  of  course,  a  weighted  one,  i.e. 
an  average  in  which  each  kind  of  goods  is  given  an  im- 
portance consistent  with  the  proportionate  value  of  it 
sold.  By  the  method  of  averaging  here  described,  it  is 
obvious  that,  given  costless  transfer  of  all  goods  and 
services,  the  average  price  or  price  level  in  the  one  coun- 
try would  equal  the  average  in  the  other ;  for  all  prices 
would  be  exactly  the  same  in  each,  and  an  average, 
weighted  or  unweighted,  must  be  the  same. 

As  it  is,  however,  the  goods  which  are  the  special 
product  of  each  country  tend  to  be  lower  in  that  country, 
and  to  be  higher  in  other  countries,  by  an  amount  equal 
to  the  cost  of  transportation  and  other  obstacles  in  the 
way  of  trade.  This  makes  it  unlikely  that  the  average 
of  prices  in  one  country  will  be  the  same  as  the  average 
in  another  country.  Thus,  wheat  may  be  lower  in  price 
in  Canada  than  in  England  by  the  cost  of  transporta- 
tion. At  the  same  time,  cotton  cloth  may  be  lower  in 
price  in  England  by  the  cost  of  transportation.  There 

1  Cf.  Fisher's  suggestion  for  comparing  the  price  levels  in  the  same  country 
for  two  or  more  years,  Elementary  Principles  of  Economics,  New  York  (Macmil- 
lan),  1912,  p.  250. 


6      ECONOMIC  ADVANTAGES  OF  COMMERCE 

is  no  logical  reason  for  assuming  that  the  average  of 
prices  (the  level  of  prices)  is  the  same.  The  lower  priced 
wheat,  in  Canada,  may  conceivably  have  so  great  an 
importance  as  to  make  the  weighted  average  of  prices 
lower  there,  despite  the  higher  relative  price  of  cotton 
cloth.  Or  cotton  cloth,  cutlery,  shoes,  and  machinery, 
all  lower  in  England,  may  make  average  prices  lower 
there  even  though  wheat  is  lower  in  Canada.  Or  again, 
though  many  articles  may  be  lower  in  price  in  England, 
yet  these  may  be  for  the  most  part  such  things  as  houses, 
practically  non-transportable,  or  goods  transportable 
only  at  such  great  expense  as  generally  not  to  be  trans- 
ported. A  few  things  may  be  lower  in  Canada  by  enough 
to  pay  for  shipment  to  England.  Under  these  circum- 
stances, average  prices  will  certainly  be  lower  in  England 
although  trade  may  be  in  perfect  equilibrium.  A  dollar 
(or  its  mint  equivalent  in  English  money)  will  buy  more 
in  England,  yet  Canadian  money  will  not  flow  to  Eng- 
land for  goods  transportable  at  great  expense,  in  any 
larger  quantity  than  English  money  will  flow  to  Canada 
for  a  few  goods  only  slightly  cheaper  in  Canada  but 
easily  transported.  Wheat  may  be  enough  lower  in 
Canada  to  pay  for  export,  and  cotton  cloth  enough  lower 
in  England.  Everything  else  may  be  lower  in  Eng- 
land, yet  not  enough  lower  for  shipment  to  Canada. 
If  this  is  the  situation,  the  general  level  of  prices  in 
England  must  be,  and  must  remain,  lower  than  in 
Canada. 

But  though  the  price  levels  of  England  and  Canada 
are  not;  on  these  hypotheses,  the  same,  they  are  never- 
theless related.  The  level  of  prices  in  England  may  be 
continuously  lower,  but  will  be  lower  only  to  a  certain 
extent.  A  rise  of  Canadian  prices  (the  result  of  gold 


INTERCOMMUNITY  TRADE  7 

discoveries,  expansion  of  bank  credit,  inflow  of  gold 
from  the  United  States,  or  other  cause)  will  increase 
the  importations  by  Canada  from  England,  despite 
transportation  and  other  obstacles,  and  will  tend  to 
raise  English  prices  also,  thus  leaving  the  relation  between 
Canadian  and  English  prices  substantially  as  before. 
Similarly  a  rise  in  English  prices  will  affect  prices  in 
Canada ;  and  a  fall  of  prices  in  either  country  will  affect 
prices  in  the  other. 

§2 

What  Prices  Tend  to  be  Lower  in  a  Given  Country,  than 
Prices  of  the  Same  Kinds  of  Goods  in  Another 
Country 

It  is  apparent  that  prices  of  all  goods  are  not  likely 
to  be  lower  in  one  country  than  in  another  if  transporta- 
tion and  tariff  conditions  are  such  as  to  make  any  appre- 
ciable trade  profitable.  For  unless  the  cost  of  trans- 
portation, plus  other  obstacles,  is  very  great,  the  low 
prices  in  the  one  country  will  cause  flow  of  gold  in  that 
direction.  This  will  continue  until  the  price  of  some 
good  or  goods  becomes  lower  in  the  previously  high  price 
country  than  in  the  other.1  The  condition  of  equilib- 
rium will  be  realized  at  a  point  such  that  some  prices 
are  lower  in  the  one  country  and  some  lower  in  the  other. 
This  may  be  called  a  moving  equilibrium,  or  an  equi- 
librium such  that,  other  things  equal,2  about  the  same 
value  of  trade  would  flow  in  each  direction. 

1  This  principle  is  expressed  with  great  clearness  in  Taussig's  Principles  of 
Economics,  New  York  (Macmillan),  191 1,  Vol.  I,  pp.  486,  487. 

2  A  gold  mining  country  may  export  a  surplus  of  gold  and  import  a  surplus 
of  other  things,  but  exports  and  imports  as  a  whole,  none  the  less,  tend  to  be 
equal.      A  country  which  has  large  investments  abroad  will  usually  import 
more  than  it  exports  of  goods  in  general.     See  Part  I,  Ch.  V,  §  7. 


8       ECONOMIC  ADVANTAGES  OF  COMMERCE 

The  conclusion  that  some  prices  will  be  lower  in  one 
country  and  some  prices  in  others,  is  true  in  principle 
even  if  the  countries  trading  have  different  monetary 
standards,  e.g.  if  one  country  has  a  gold  and  the  other 
a  paper  standard.  We  saw,  in  the  last  chapter,  that 
whatever  the  relation  or  the  non-relation  of  the  monetary 
standards  of  two  countries,  trade  might  take  place  be- 
tween them ;  and  that  the  flow  of  this  trade  in  one  direc- 
tion would  tend,  in  the  long  run,  to  equal  the  flow  in 
the  other.1  Any  tendency  to  an  excess  flow  in  one  direc- 
tion would  be  self-terminating.  When  the  position  of 
equilibrium  was  established,  some  prices  would  be  the 
lower  in  each  country  in  the  sense  that  the  money  of 
either  country  would,  through  the  process  of  gold  ship- 
ment or  through  the  mechanism  of  the  exchanges,  buy 
more  of  some  goods  in  the  other  country  than  at  home. 

What  conditions  determine  which  prices  shall  be  lower 
in  one  country  than  in  another  or  others  ?  The  answer 
is:  those  goods  are  lower  in  price  in  any  country,  for 
the  production  of  which  it  has  relatively  great  advan- 
tages. These  advantages  may  lie  in  geographical  posi- 
tion, may  depend  upon  soil  and  climate  or  the  posses- 
sion of  certain  mines  or  other  natural  resources,  or  may, 
in  certain  lines  of  activity,  depend  upon  high  acquired 
efficiency  of  labor.  Those  goods  in  the  production  of 
which  a  country  has  a  relative  advantage  and  which, 
therefore,  it  sells  at  a  low  money  price,  will,  of  course, 
assuming  trade  to  be  free,  be  the  things  it  exports.  The 
people  of  other  countries  will  avail  themselves  of  the 
opportunity  to  buy  these  goods  cheaply.  The  advan- 
tages for  producing  them  will  mean  a  large  amount  of 
labor  and  capital  specializing  in  their  production  in  the 

1  See  Part  I,  Ch.  VI,  §§  6,  7,  8,  9. 


INTERCOMMUNITY  TRADE  9 

exporting  country.  Since  the  low  prices  at  which  these 
goods  are  sold  result  from  the  relative  advantages  in 
that  country  for  their  production,  therefore  these  low 
prices  do  not  signify  that  the  industries  are  unprofitable. 
So  much  can  be  produced  with  a  given  amount  of  labor 
that,  even  at  low  prices,  the  yield  to  industry  is  high. 

Similarly,  the  existence  of  a  high  level  of  money  wages 
in  any  country,  does  not  mean  that  in  such  a  country 
some  goods  cannot  be  produced,  and  exported,  at  low 
money  cost.  The  United  States  may  have  money  wages 
twice  as  high,  per  day,  as  England.  Yet  if  the  American 
agricultural  laborer  can  produce  over  twice  as  much 
wheat  per  day,  because  of  the  extent  of  good  agricultural 
land,  as  can  be  produced  in  England  with  the  same  labor, 
then  the  money  cost  of  the  American  wheat  will  be  no 
greater  and  may  be  appreciably  less  per  bushel.  In 
selling  his  wheat  in  the  foreign  market,  the  farmer  is  not 
primarily  concerned  with  the  matter  of  how  much  he 
has  to  pay  his  men  by  the  day.  He  is  greatly  concerned 
with  the  matter  of  what  he  must  pay  them  per  bushel 
produced.  It  is  obvious,  therefore,  that  a  productive 
country  can  have  at  the  same  time  low  prices  of  goods 
which  it  exports,  and  high  wages  to  the  producers  of 
those  goods. 

Neither  is  it  essential,  in  order  for  a  country  to  export 
certain  goods  at  a  low  price,  that  it  should  be  able  to 
produce  those  goods  more  efficiently,  i.e.  with  less  labor 
expenditure,  than  other  countries.  All  that  is  neces- 
sary is  that  for  the  production  of  such  goods,  its  disad- 
vantages shall  be  less  than  for  the  production  of  other 
goods.  The  converse  of  this  proposition  is  that  all 
goods  will  not  necessarily  be  produced  at  the  lowest 
price,  in  the  country  where  they  can  be  produced  with 


io      ECONOMIC  ADVANTAGES  OF  COMMERCE 

least  labor.  Even  if  the  United  States  can  produce 
woolen  cloth  with  less  labor  expenditure  than  England, 
the  advantage  of  the  United  States  in  the  production 
of  steam  and  electric  engines  and  other  machinery,  may 
be  still  greater.  If  a  given  amount  of  labor  in  the  United 
States  will  produce  io  per  cent  more  woolen  cloth  or 
zoo  per  cent  more  engines  and  machinery  than  in 
England,  then  the  United  States  gains  more  by  produc- 
ing the  engines  and  machinery  and  importing  the  cloth. 
The  price  at  which  producers  in  the  United  States  could 
afford  to  sell  machinery,  etc.,  would  therefore  be  com- 
paratively low,  while  it  would  require  a  relatively  high 
price  of  woolen  cloth  to  induce  Americans  to  manufac- 
ture it.  On  our  assumption,  American  labor  and  capital 
can  secure  more  money,  in  the  English  market,  for  the 
product  of  a  day's  labor  in  making  machinery  than  for 
the  product  of  a  day's  labor  in  a  cloth  factory,  and  still 
undersell  English  machine  makers.  On  the  other  hand, 
English  labor  and  capital  can  get  more  money  by  selling, 
in  the  United  States,  the  product  of  a  day's  labor  in  the 
cloth  factory,  than  for  the  product  of  a  day's  labor  in 
an  English  machine  making  factory,  and  yet  undersell 
American  cloth.  If  the  United  States  is  absolutely 
more  productive  in  both  lines,  as  well  as  in  most  or  all 
others,  it  might  be  better,  economically,  for  the  people  of 
England  to  migrate  to  the  United  States.  But  so  long 
as  they  choose  to  remain  in  England,  they  will  be  better 
off  if  they  specialize  in  the  production  of  cloth. 

It  appears,  therefore,  that  under  conditions  of  entire 
free  trade,  there  would  be  a  high  degree  of  geographical 
specialization ;  and  that  each  industry  would  be  located 
where  the  facilities  for  it  were  relatively  the  best,  all 
things,  including  transportation  cost,  considered.  In 


INTERCOMMUNITY  TRADE  n 

fact,  of  course,  the  location  of  industries  is  considerably 
affected  by  tariffs.  The  higher,  and  the  greater  in 
number,  are  these  trade  restrictions,  the  more  largely 
is  industry  turned  from  its  natural  channels.  If  there 
were  a  sufficiently  high  tariff  around  the  borders  of  Maine, 
cotton  could  perhaps  be  raised  in  Maine  hothouses. 
Similarly,  a  high  tariff  levied  by  South  Carolina  on  steel 
rails  brought  in  across  its  boundaries,  might  encourage 
the  manufacture  of  steel  rails  for  use  within  the  state, 
in  the  midst  of  the  South  Carolina  rice  fields,  with  iron 
brought  from  the  Lake  Superior  ore  regions  and  coal 
imported  from  Pennsylvania. 

§3 

Trade  between  Two  Communities  when  Each  has  an  Ab- 
solute Advantage  over  the  Other,  in  One  or  More  Lines 
of  Production 

Let  us  now  illustrate  how  the  case  stands  as  to  prices 
and  gains  from  trade  when  two  communities  engage 
in  trade,  each  having  an  absolute  advantage  in  one  line 
of  activity  over  the  other.  We  shall  suppose  the  trade 
to  be  between  two  of  the  states  of  our  own  country, 
South  Dakota  and  Indiana.  South  Dakota  we  shall 
take  as  an  example  of  a  wheat-producing  section  and 
Indiana  as  an  example  of  a  corn-producing  section. 
Suppose  that  one  day's  labor  in  South  Dakota,  of  one 
man,  produces  2  bushels  of  wheat  or  i  bushel  of  corn, 
while  in  Indiana  the  same  amount  of  labor  produces  i 
bushel  of  wheat  or  2  bushels  of  corn.  Assume,  also,  no 
cost  of  transportation  and  no  tariff  interferences  with 
trade.  If  wheat  sells  in  South  Dakota  for  $i  per  bushel, 
then  a  day's  labor  in  the  wheat  fields  will  yield  $2.  No 


12     ECONOMIC  ADVANTAGES  OF  COMMERCE 

one,  therefore,  will  be  satisfied  to  produce  corn  in  South 
Dakota  for  less  than  $2  a  day.  But  since  only  i  bushel 
of  corn  can  be  produced,  $2  reward  will  necessitate 
a  price  of  $2  a  bushel.  Whatever  the  price  of  wheat, 
corn  must  sell,  if  produced  in  South  Dakota,  at  double 
that  price  per  bushel;  and  therefore,  if  we  assume  $i 
per  bushel  for  wheat,  corn  must  sell  at  $2.  No  one 
in  South  Dakota  will  produce  it  for  appreciably  less. 
If  it  can  be  imported  for  less,  it  will  be. 

With  Indiana  the  case  is  reversed.  Corn,  by  our 
assumption,  is  produced  there  the  more  easily.  If  the 
corn  can  be  sold  for  $i  a  bushel,  it  will  give  producers 
$2  a  day.  Naturally  they  will  not  care  to  produce  wheat 
for  a  less  return,  and  therefore,  if  Indiana  is  less  adapted 
to  wheat  production,  they  must  get  a  higher  price  ($2 
a  bushel)  in  order  to  encourage  its  production  in  Indiana. 

Both  states  gain  by  the  trade.  South  Dakota  can 
produce  in  two  days'  labor,  2  bushels  of  wheat  at,  say, 
$i  per  bushel  and  i  bushel  of  corn  at  $2  a  bushel,  a  total 
of  3  bushels  or  $4  worth.  Indiana  can  produce  in  two 
days  of  labor,  i  bushel  of  wheat  at  $2  and  2  bushels  of 
corn  at  $i  a  bushel,  making  a  total  of  3  bushels  or  $4 
worth.  If  they  trade,  each  state  can  specialize.  South 
Dakota  can  produce  in  two  days  of  labor,  4  bushels  of 
wheat  at  $i  per  bushel,  or  $4  worth ;  while  Indiana  can 
produce  with  two  days  of  labor  available,  4  bushels 
of  corn  at  $i  each  or  $4  worth.  Trade  between  the 
two  states  will  make  it  possible  (assuming  an  even  ex- 
change) for  each  state  to  get,  from  its  two  days  of  labor, 
2  bushels  of  corn  and  2  bushels  of  wheat,  instead  of 
2  of  one  cereal  and  i  of  the  other.  There  will  be  no  gain 
in  money  values.  In  either  case  the  total  is  $4  worth 
for  each  state.  But  there  will  be  a  considerable  differ- 


INTERCOMMUNITY  TRADE  13 

ence  in  what  the  money  will  buy.  In  the  case  we  have 
assumed,  money  incomes  will  be  the  same  with  the  trade 
as  without  it,1  but  the  money  "cost  of  living "  will  be 
appreciably  reduced;  $4  will  buy  a  total  of  4  bushels 
instead  of  only  3. 

It  is  clear  that,  under  our  assumed  conditions,  Dakota 
wheat  and  Indiana  corn  could  and  would  be  sold  the 
more  cheaply;  that,  therefore,  the  people  of  Indiana 
would  naturally  buy  Dakota  wheat  at  a  lower  price 
(e.g.  $i)  rather  than  Indiana  wheat  at  a  higher  (e.g.  $2), 
while  the  people  of  South  Dakota  would  choose  to  buy 
corn  from  Indiana ;  also  that  this  arrangement,  so  obvi- 
ously to  the  individual  interests  of  the  persons  concerned, 
would  make  both  states  the  richest.  Is  it  necessary 
to  point  out  that  what  is  true  as  regards  two  states,  terri- 
tories, or  sections  under  the  same  general  government, 
is  also  true  of  two  different  nations?  If  Indiana  and 
South  Dakota  gain  by  such  a  trade  when  united  as  parts 
of  one  nation  by  the  government  at  Washington,  it  is 
reasonable  to  suppose  that  they  would  gain  in  just  the 
same  way  and  to  the  same  extent  if  each  were  a  separate 
nation.  And  in  an  exactly  analogous  way,  the  United 
States  gains  by  trade  with  Canada. 

§4 

Trade  between  Two  Communities  or  Countries  when  One 
is  More  Productive  than  the  Other  in  Several  or  in  All 
Lines,  but  has  a  Greater  Advantage  in  One  Line  or  in 
a  Few  Lines  than  in  the  Rest. 

Let  us  next  illustrate  the  relations  of  money  prices, 
and  the  gains  from  trade,  when  one  country  or  community 

1  See,  however,  Ch.  IV  (of  Part  II),  §  2. 


14     ECONOMIC  ADVANTAGES  OF  COMMERCE 

has  an  advantage  over  another  in  several  or  in  all  lines, 
but  a  greater  advantage  in  one  than  in  the  others.  As- 
sume that  in  Canada  one  man's  labor  for  a  week  will 
produce  20  bushels  of  wheat  or  14  yards  of  linen  cloth, 
while  in  Ireland,  a  week's  labor  of  one  man  will  produce 
6  bushels  of  wheat  or  10  yards  of  cloth.  Ireland  is  at 
a  disadvantage  in  both  lines,  but  her  disadvantage  is 
less  in  linen  manufacture,  and  Canada's  advantage  is 
greater  in  wheat  production.  Both  gain  if  Ireland  pro- 
duces linen  and  Canada  produces  wheat  and  they  trade. 
Without  trade,  two  weeks  of  labor  in  Canada,  equally 
divided,  would  produce  20  bushels  of  wheat  and  14  yards 
of  linen.  In  Ireland,  two  weeks  of  labor  would  produce 
6  bushels  of  wheat  and  10  yards  of  linen.  Similarly, 
four  weeks  of  labor  in  Ireland  would  produce  12  bushels 
of  wheat  and  20  yards  of  linen.  Suppose,  now,  that  they 
trade,  and  that  a  bushel  of  Canadian  wheat  buys  a 
yard  of  Irish  linen.  Then  Canada  can  produce,  in  two 
weeks,  40  bushels  of  wheat,  and,  by  trading  half  of  it 
for  linen,  have  20  bushels  plus  20  yards,  instead  of  20 
plus  14.  Ireland  can  produce  in  two  weeks  20  yards  of 
linen,  or  in  four  weeks,  40  yards.  By  trading  half  of  this 
linen  for  wheat,  Ireland  will  have  20  yards  plus  20 
bushels  instead  of  20  plus  12,  as  a  reward  for  four  weeks' 
work.  On  our  present  hypothesis,  Ireland  must  ex- 
change the  product  of  two  weeks'  work  with  the  product 
of  one  week  of  work  in  Canada,  yet  gains  more  by  so 
doing  than  can  be  gained  by  refraining  from  the  exchange 
of  goods. 

That,  in  the  absence  of  trade  restrictions  or  excessive 
cost  of  transportation,  such  trade  will  automatically 
take  place,  becomes  evident  so  soon  as  we  ask  what 
prices  will  be  charged  by  the  producers  in  each  country. 


INTERCOMMUNITY  TRADE  15 

If  Canadians  are  able  to  produce  wheat  for  $i  a  bushel 
(and,  therefore,  $20  a  week),  they  will,  of  course,  be 
unwilling  to  produce  linen  for  any  smaller  weekly  re- 
turn, i.e.  for  less  than  $20  for  14  yards,  or  $1.43  a  yard. 
If  linen  can  be  imported  from  Ireland  for  less  than 
$1.43,  say  for  $i  a  yard,  Canadian  wheat  producers 
will  buy  it  from  Ireland,  and  would-be  Canadian 
linen  manufacturers  will  find  more  profitable  employ- 
ment in  wheat  raising. 

On  the  other  hand,  Irish  producers,  if  selling  linen  to 
Canada  at  $i  a  yard,  will  be  earning  only  $10  a  week, 
though  considerably  more  than  they  could  earn  produc- 
ing 6  bushels  of  wheat  at  $i  a  bushel.  To  induce  an 
Irish  linen  worker,  under  these  circumstances,  to  enter 
wheat  production,  would  require  $10  a  week  or  $1.67 
per  bushel.  Hence,  Irish  linen  producers  will  prefer 
to  buy  wheat  in  Canada ;  and,  with  Canada  demanding 
Irish  linen,  Irish  wheat  producers  will  find  a  more  prof- 
itable occupation  in  making  linen.  As  we  have  seen,1 
it  is  altogether  probable  that  some  goods  will  be  lower 
in  price  in  each  country  than  in  the  other.  All  prices 
could  not  long  be  lower  in  either,  since  the  resulting  in- 
flow of  gold  would  raise  them.  While  there  is  no  special 
virtue  in  the  particular  prices  of  $i  a  bushel  and  $i  a 
yard  here  assumed  for  illustration,  the  conditions  of 
production  in  each  country,  as  stated  in  the  hypothesis, 
are  such  as  would  make  the  wheat  of  Canada  and  the 
linen  of  Ireland  the  cheaper  goods. 

Trade  between  nations,  as  well  as  trade  between  parts 
of  the  same  nation,  results  in  a  gain  to  both  sides,  for  it 
makes  possible  geographical  specialization  and  therefore 
a  more  productive  employment  of  the  factors  of  industry. 

1  §  2  of  this  chapter  (I  of  Part  II). 


16     ECONOMIC  ADVANTAGES  OF  COMMERCE 

In  theoretical  discussion,  international  trade  is  sometimes 
separated  from  intranational  trade,  because  of  the  fact 
that  labor  and  capital  flow,  as  a  rule,  with  greater  diffi- 
culty, from  one  nation  to  another.1  Distance  and  ex- 
pense, a  strange  government,  separation  from  old  friends 
and  old  associations,  unfamiliar  customs,  different  lan- 
guage, different  religion,  —  any  or  all  of  these  considera- 
tions may  prevent  the  free  movement  of  labor  from  one 
country  to  another.  Some  of  them  will  cause  hesitancy 
in  making  foreign  investments.  The  argument  is  that 
within  a  nation,  labor  and  capital  will  move  freely  to 
those  localities  where  they  receive  the  largest  return. 
If  Connecticut  were  more  productive  in  every  way2 
than  Massachusetts,  then  labor  and  capital  from  Massa- 
chusetts would  flow  freely  into  Connecticut  until  condi- 
tions3 were  equalized,  until  the  greater  crowding  of 
Connecticut  and  the  less  crowding  of  Massachusetts 
in  comparison  with  resources,  made  labor  and  capital 
no  more  productive  in  the  former  than  in  the  latter  state. 
If  Massachusetts  had  superiority  in  some  lines  and 
Connecticut  in  others,  they  would  trade ;  while  if  Con- 
necticut were  superior  in  all  lines,  Massachusetts  people 
would  largely  migrate.  But  if  labor  in  the  United 
States  is  more  productive  than  in  England,  even  in  all 
lines,  most  of  the  English  people  may  nevertheless  pre- 
fer to  stay  at  home.  They  will  then  simply  produce 
those  things  in  which  their  disadvantage  is  least.  There 
is  really  no  difference  in  principle  between  international 
and  intranational  trade,  as  such.  In  any  case  there  is 
some  immobility  of  labor  and  capital.  In  any  case 
a  sufficient  inducement  will  at  least  partly  overcome 

1  See  Mill,  Principles  oj  Political  Economy,  Book  III,  Ch.  XVII,  §  i. 

2  At  the  margin  of  production.  3  At  the  margin. 


INTERCOMMUNITY  TRADE  17 

the  immobility,  —  witness  the  flow  of  Italian,  Greek, 
and  Polish  labor  into  the  United  States.  So  the  differ- 
ence is  one  of  degree  and  not  one  of  kind.  Also,  such 
difference  as  exists  may  be  as  marked  between  widely 
separated  parts  of  the  same  nation  or  empire,  e.g. 
Maine  and  Montana,  or  Ireland  and  Canada,  as  between 
different  nations,  e.g.  Germany  and  Austria.  In  either 
case,  so  long  as  labor  and  capital  remain  where  they  are, 
specialization  is  worth  while. 

§5 

Summary 

In  this  chapter  we  have  discussed  trade  from  the 
standpoint  of  relations  of  prices  and  price  levels,  loca- 
tion of  industries,  and  the  gains  of  trade.  Through 
the  influence  of  trade,  the  price  in  any  country  of  any 
kind  of  goods  tends  towards  equality  with  the  price  in 
other  countries.  The  difference  will  not  much  exceed 
cost  of  carriage  plus  tariffs,  etc.  As  a  consequence, 
the  price  level  of  one  country  is  related,  if  they  have  a 
common  value  standard,  e.g.  gold,  to  the  price  level  of 
other  countries,  but  is  unlikely  to  be  the  same.  The 
prices  of  some  goods  are  lower  in  one  country  and  the 
prices  of  other  goods  are  lower  in  other  countries,  accord- 
ing to  what  each  country  can  produce  with  greatest 
relative  advantage. 

If  a  country  has  great  advantages  for  production  in 
any  line,  it  can  produce  in  that  line  with  great  profit 
and  can  pay  high  wages,  while  yet  selling  abroad  at  low 
prices,  the  goods  so  produced.  It  is  not  necessary  in 
order  that  a  country  shall  export  certain  goods  at  a  low 
price,  that  it  shall  be  able  to  produce  those  goods  with 
PART  n  —  c 


i8     ECONOMIC  ADVANTAGES  OF  COMMERCE 

less  effort  than  their  production  would  require  elsewhere ; 
but  only  that  its  disadvantage  shall  be  less  in  that  line 
than  in  others.  On  the  other  hand,  if  one  country  has 
an  advantage  over  another  in  nearly  all  lines,  but  a  greater 
advantage  in  some  lines  than  others,  it  gains  most  by 
specializing  in  those  lines  where  its  advantage  is  greatest. 
Under  conditions  of  free  trade,  there  would  be,  then,  a 
large  amount  of  geographical  specialization,  each  country 
devoting  its  energies  to  those  lines  where  its  productive 
capacity  is  relatively  the  greatest.  Industry  is  turned 
the  more  from  the  lines  it  would  otherwise  follow  in 
each  country,  the  more  widely  and  intensively  restric- 
tion is  followed.  »  The  gains  from  trade,  when  each  of 
two  communities  has  an  absolute  advantage  over  the 
other,  and  when  each  has  a  relative  advantage  in 
some  line,  were  illustrated  by  hypothetical  figures. 

The  distinction  sometimes  made  between  international 
and  intranational  trade  was  referred  to,  viz.,  that  in 
the  latter  case,  greater  advantages  of  one  community 
in  all  lines  would  cause  movement  of  population,  while 
in  the  former,  immobility  of  labor  and  capital  is  more 
in  evidence.  In  the  former  case  (that  of  international 
trade),  therefore,  differences  in  relative  advantages  may 
sometimes  be  the  principal  basis  of  trade.  But  it  was 
pointed  out  that  this  distinction  is  but  a  distinction  in 
degree,  and  that,  in  any  case,  political  boundaries  are 
often  less  important  factors  in  immobility  of  labor  and 
capital  than  distance  and  natural  barriers. 


CHAPTER  II 

THE  RATE  OF  INTERCHANGE  OF  GOODS  BETWEEN  COM- 
MUNITIES 


The  Limits  to  the  Rate  at  which  the  Goods  of  One  Country 
Exchange  for  Those  of  Another 

WE  have  seen  that  differences  in  relative  productive- 
ness bring  about  trade  between  communities  if  there  are 
no  natural  or  artificial  barriers  or  if  these  barriers  are 
not  unduly  great ;  and  that  both  communities  concerned 
gain  by  such  trade.  How  much  each  community  gains 
depends  on  the  rate  at  which  the  goods  of  one  community 
exchange  for  those  of  the  other.  There  are  certain  limits 
between  which  this  rate  fluctuates,  and  at  a  rate  of 
exchange  of  goods  beyond  these  limits,  on  either  side, 
there  would  be  no  trade. 

In  showing  what  these  limits  are,  we  will  again  take 
trade  between  Ireland  and  Canada  for  illustration.  We 
assumed  that  a  week's  labor  in  Canada  would  produce 
20  bushels  of  wheat  or  14  yards  of  linen.  We  saw,  also, 
that  if  Canadians  could  get  $i  a  bushel  for  wheat,  they 
would  be  willing  to  produce  linen  for  $1.43  a  yard,  but 
not  for  less.  Since  Canadian  wheat  producers  could 
buy  this  cloth  at  home  for  $1.43  a  yar4,  they  would  not 
pay  more  than  $1.43  a  yard  for  linen  cloth  brought 
from  Ireland.  At  a  price  greater  than  $1.43  per  yard, 
they  would  cease  to  buy.  If  wheat  is  $i  a  bushel,  then 

19 


t 
20      ECONOMIC  ADVANTAGES  OF  COMMERCE 

a  price  of  $1.43  a  yard  for  linen  means  that  1.43  bushels 
of  wheat  must  be  sold  for  each  yard  of  linen  bought. 
This,  then,  is  one  of  the  limits  beyond  which  trade  will 
not  go.  If  Canadians  have  to  give  up  more  than  1.43 
bushels  of  wheat  to  get  a  yard  of  Irish  linen,  they  will 
lose  by  the  trade ;  if  less,  they  will  gain  by  it,  i.e.  will 
get  more  cloth  by  exchanging  a  week's  wheat  yield  for 
cloth  than  by  devoting  a  week  to  cloth  production. 
The  same  principle  applies  if  the  level  of  prices  in  Canada 
is  higher  or  lower.  Suppose  Canadian  wheat  could  be 
sold  for  $2  a  bushel.  Then  the  product  of  a  week's 
labor,  20  bushels,  would  yield  $40.  Obviously,  therefore, 
since  a  week's  labor  in  linen  production  would  yield, 
in  Canada,  but  14  yards,  a  price  of  $2.85  a  yard  would 
be  required  for  its  production  there.  In  this  case,  it 
would  pay  Canadians  to  devote  themselves  to  wheat 
production  and  sell  their  wheat  at  $2  a  bushel,  so  long 
as  they  could  buy  linen  abroad  at  less  than  $2.85  a  yard. 
At  this  price  or  a  greater,  they  would  no  longer  gain. 
But  we  have  merely  restated  our  limit  in  terms  of  a  new 
price  level.  At  $2.85  a  yard,  Canadians  would  be  parting 
with  1.43  bushels  of  wheat  for  each  yard  of  linen.  What- 
ever the  price  level,  therefore,  so  long  as  20  bushels 
requires,  in  Canada,  the  same  productive  effort  as  14 
yards,  the  limit  beyond  which  Canadians  would  refuse 
to  trade  is  1.43  bushels  per  yard.  At  any  less  price  of 
linen,  Canadians  would  gain,  and  the  lower  the  price, 
the  greater  the  gain  to  Canada.  The  principle  applies, 
also,  if  the  trading  countries  have  entirely  different 
monetary  standards.  If  Canada  had  an  inconvertible 
paper  money,  there  would  still  be  some  price  in  this 
money,  for  Irish  linen,  some  amount  of  this  money  neces- 
sary to  buy  the  foreign  exchange  or  the  gold  to  pay  for 


THE  RATE  OF  INTERCHANGE  OF  GOODS  21 

Irish  linen.  It  would  still  be  true  that  a  yard  of  linen 
produced  in  Canada  would  cost  1.43  times  as  much  as  a 
bushel  of  wheat.  If  the  amount  of  this  money  neces- 
sary to  buy  a  yard  of  linen  in  Ireland  should  be  more  than 
1.43  times  the  cost  of  a  bushel  of  Canadian  wheat,  the 
linen  would  not  be  imported. 

Beyond  one  limit,  Canada  would  gain  nothing  and 
would,  therefore,  refuse  to  trade.  Beyond  the  other 
limit,  Ireland  would  gain  nothing  and  would  refuse  to 
trade.  The  trade,  if  carried  on,  must  benefit  both,  and 
will  therefore  lie  between  these  limits.1  Let  us  see  what 
is  the  limit  beyond  which  Ireland  would  not  trade.  If  a 
week's  labor  in  Ireland  will  produce  10  yards  of  linen 
or  6  bushels  of  wheat,  and  linen  sells  for  $i  a  yard,  then 
Irish  producers  would  be  willing  to  raise  wheat  for  $1.67 
a  bushel  but  not  for  less.  Since  the  Irish  linen  manu- 
facturing population  can  get  wheat  at  home  by  paying 
$1.67  a  bushel,  to  pay  more  for  Canadian  wheat  would 
involve  a  loss.  If  linen  is  $i  a  yard,  therefore,  Ireland 
will  profit  by  purchasing  Canadian  wheat,  at  any  price 
up  to  $1.67  a  bushel.  Beyond  that  price,  Ireland  will 
refuse  to  buy  from  Canada,  preferring  to  produce  the 
needed  wheat  at  home.  Similarly,  if  linen  made  in 
Ireland  should  sell  for  $0.50  a  yard,  Irish  linen  makers 
could  be  induced  to  produce  wheat  for  about  $0.83  a 
bushel,  and  that  would,  therefore,  be  approximately 
the  limit  to  what  Irish  linen  makers  would  pay  for 
Canadian  wheat.  In  other  words,  whatever  the  level 
of  prices,  the  most  that  Irish  linen  makers  would  pay 
for  a  bushel  of  Canadian  wheat  would  be  1.67  yards  of 

1  Mill,  Principles  of  Political  Economy,  Book  III,  Ch.  XVIII,  §  2.  On  the 
general  theory  of  international  values  the  mathematical  reader  may  be  referred 
to  Edgeworth,  "  The  Theory  of  International  Values,"  Economic  Journal,  Vol. 
IV,  1894,  pp.  35-50,  424-443,  606-638. 


22      ECONOMIC  ADVANTAGES  OF  COMMERCE 

linen.  At  any  less  price  they  would  gladly  buy.  At  a 
more  unfavorable  rate,  they  would  lose,  and  so  would 
refuse  to  trade.  We  have  found,  then,  the  two  limits 
to  exchange.  Between  1.43  bushels  for  i  yard  and  1.67 
yards  for  i  bushel,  the  rate  of  interchange  must  lie  if 
there  is  to  be  any  trade  at  all.  1.67  yards  for  i  bushel 
is  the  same  as  i  yard  for  .60  bushels.  Therefore,  the 
rate  of  trade  must  lie  between  1.43  bushels  =  i  yard, 
and  .60  bushel  =  i  yard.  At  either  limit,  all  the  gain 
from  trade  would  go  to  one  or  the  other  of  the  two  trad- 
ing communities.  Between  these  limits,  the  gain  would 
be  divided  equally  or  unequally  between  those  commu- 
nities. 

§2 

Conditions  of  Supply  and  Demand  Determining  the  Exact 
Rate  of  Interchange  between  these  Limits 

The  question  which  has  how  to  be  answered  is,  what 
determines  the  exact  rate  of  interchange  —  and,  there- 
fore, the  gain  to  each  country  —  between  these  limits. 
We  shall  find  the  determining  factor  to  be  relative  in- 
tensity of  demand,  or,  to  use  more  familiar  terms,  we 
shall  find  the  rate  to  be  determined  by  supply  and  demand. 
Returning  to  our  illustration,  let  us  suppose  that  at  a 
price  of  $i  a  bushel  for  wheat  and  $i  a  yard  for  linen, 
Ireland  wants  more  bushels  of  wheat  from  Canada 
than  Canada  desires  yards  of  linen  from  Ireland.  In 
other  words,  Ireland's  intensity  of  demand  for  wheat  at 
these  prices  of  wheat  and  linen,  is  greater  than  Canada's 
intensity  of  demand  for  linen.  An  excess  of  money  would 
then  flow  into  Canada  and  prices  in  Canada  would  rise, 
while  in  Ireland  they  would  fall.1  This  would  continue 

1  Throughout  this  book  it  should  be  borne  in  mind  that  the  rise  and  fall  may 
be  only  relative.  There  may  be  a  general  rise  of  prices,  in  which  case  Canadian 


THE  RATE  OF  INTERCHANGE  OF  GOODS  23 

until  a  scale  of  prices  was  reached  at  which  trade  would 
be  in  equilibrium,  i.e.  at  which  Canada  would  buy  as 
many  dollars'  worth  of  linen  as  Ireland  would  buy  of 
wheat.1  Let  us  suppose  that  this  stage  is  reached  when 
the  quantity  of  money  in  Canada  is  yj-  of  its  former 
amount,  and  in  Ireland  (having  smaller  population, 
wealth,  and  currency,  and  being,  therefore,  affected 
through  an  inflow  or  outflow,  by  a  greater  per  cent), 
|  of  its  former  amount.2  Then,  by  the  quantity  theory 
of  money,  prices  in  Canada  would  be  some  10  per  cent 
higher  than  previously.  Assuming  Canadian  prices 
all  to  rise  in  this  proportion,3  Canadian  wheat  would  sell 
for  $1.10  a  bushel.4  Canadians  would  now  be  unwill- 
ing to  make  linen  for  less  than  |f  of  this,  or  $1.57 
a  yard.  On  the  other  hand,  Irish  linen  would  sell  for 

prices  rise  in  greater  degree  than  those  of  Ireland.  Or  there  may  be  a  general 
fall  of  prices,  in  which  case  Irish  prices  fall  in  greater  degree  than  those  of  Canada. 
The  important  facts  for  our  argument  are  the  relation  of  Canadian  to  Irish  prices 
and  the  changes  in  this  relation.  The  discriminating  reader  will  easily  see  that 
none  of.  our  essential  conclusions  are  affected  by  the  qualification  here  set  forth. 

1  See  Taussig,  Principles  of  Economics,  Vol.  I,  New  York  (Macmillan),  1911, 
pp.  496,  497.    We  are  here  assuming  only  two  kinds  of  goods,  linen  and  wheat, 
to  enter  into  the  trade. 

2  If  the  difference  in  intensity  of  demand  is  slight  at  prices  of  $i  per  bushel 
and  $i  per  yard,  it  is  conceivable  that  equilibrium  may  be  reached  by  slight 
changes  in  the  rates  of  exchange,  insufficient  to  cause  a  flow  of  gold.     A  rate  of 
exchange  in  Ireland,  on  Canada,  slightly  above  par,  and  a  rate  in  Canada,  on 
Ireland,  slightly  below  par,  will  slightly  discourage  .Irish  buying  from  Canada 
(or  Canadian  selling  to  Ireland)  and  slightly  encourage  Canadian  buying  from 
Ireland  (or  Irish  selling  to  Canada). 

3  Since  the  goods  imported  from  Ireland  would  not  rise  in  price,  but  would 
fall,  and  since  these  goods  must  be  handled,  in  Canada,  by  middlemen,  other 
prices  must  rise  by  more  than  ^  to  make  an  average  rise  of  that  proportion. 
But  if  exchanging  in  Canada  the  goods  brought  from  Ireland,  forms  but  a  small 
proportion  of  Canada's  total  internal  trade  (and  it  is  not  unreasonable  to  sup- 
pose this),  then  a  rise  in  all  other  prices  of  not  much  more  than  &,  would  make 
an  average  rise  of  fully  that. 

4  The  circumstances  which  might  prevent  wheat  from  changing  to  the  same 
extent  as  many  other  prices,  are  discussed  in  later  chapters.    For  the  present, 
these  circumstances  are  assumed  to  be  non-existent. 


24    ECONOMIC  ADVANTAGES  OF  COMMERCE 

|  of  its  former  price,  or  about  $0.88.  Irish  workers 
could  now  be  induced  to  produce  wheat  for  -g0-  of  this, 
or 'about  $1.46.  This  is  cheaper  than  before  ($1.67), 
but  Ireland  would  still  gain  by  consuming  Canadian 
wheat,  while  Canada  would  gain  more  than  before  by 
purchasing  Irish  linen.  Canada  gets  more  for  her  wheat 
than  before  and  pays  less  for  her  cloth,  because  Ireland's 
demand  is  the  more  intense.  One  bushel  of  wheat  now 
gets  $3^,  and  $f  buys  a  yard  of  linen.  One  bushel 
of  wheat,  therefore,  now  buys  1.26  yards.  Ireland  gains 
less  than  before,  but  the  trade  is  still  inside  the  limit  of 
profitableness  to  Ireland.  Ireland  gives  1.26  yards  for 
one  bushel,  while  the  limit  of  profitableness  is  1.67  yards 
for  one  bushel.  At  the  new  rate  of  interchange,  Canada 
may  be  induced  to  buy  more  linen  and  Ireland 
prevented  from  buying  so  much  wheat.  Where  an 
equilibrium  is  found,  there  will  be  the  rate  of  trade.1 

Except  as  to  relations  of  money  prices,  the  conclu- 
sion is  the  same  if  the  two  countries  engaged  in  trade 
have  different  monetary  standards.  If  Canada,  for 
example,  had  paper  money  not  redeemable  in  gold, 
an  excess  demand  from  Ireland  for  Canadian  wheat 
could  not,  it  is  true,  increase  Canadian  money  or  Cana- 
dian prices ;  but  it  would,  as  we  saw  in  an  earlier  chap- 
ter,2 change  the  relative  values  of  Irish  and  Canadian 
money,  so  that  buyers  in  Ireland  of  Canadian  wheat 
must  spend  more  of  their  money  for  each  bushel  pur- 

1  Mill  suggests  that  there  may  be  several  rates  satisfying  the  conditions  of 
equilibrium,  Principles  of  Political  Economy,  Book  III,  Ch.  XVIII,  §  6.     This 
might  conceivably  be  the  case  if  the  trade  were  between  two  nations,  each  free 
of  competition  from  others,  and  if  few  articles  entered  into  the  trade.     In  the 
complications  of  actual  commercial  relations,  it  is  practically  impossible  that  it 
should  be  so. 

2  See  Part  I,  Ch.  VI,  §§  7,  8. 


THE  RATE  OF  INTERCHANGE  OF  GOODS  25 

chased,  and  so  that  Canadians  could  buy  each  yard  of 
linen  at  a  cost,  in  Canadian  money,  less  than  before. 
At  some  rate  of  interchange  of  wheat  and  linen,  the  trade 
would  balance. 

The  rate  would  be  de terminable,  also,  if  no  money 
were  used  and  trade  were  all  in  the  form  of  direct  barter. 
The  .country  having  the  more  intense  demand  would, 
as  under  existing  forms  of  trade,  offer  a  better  rate.1 
We  may,  if  we  so  desire,  say  that  at  present  a  trade 
between  communities  is  resolvable  into  two  trades,  one 
of  goods  for  money,  and  a  second  of  money  for  other 
goods.  If  we  so  look  at  the  situation,  we  may  further 
say  that  each  of  the  two  trades,  separately,  illustrates 
the  effect  of  relative  intensity  of  demand.  The  country 
which  is  the  more  anxious  to  get  the  goods  of  the  other 
will  show  a  relatively  great  intensity  of  demand  for 
money  or  gold,  giving  a  comparatively  large  amount 
of  its  own  products  for  a  given  sum  of  money;  and  it 
will  then  show  its  intensity  of  demand  for  the  desired 
products  of  the  other  country  by  giving  large  amounts 
of  money  or  gold  for  these. 

In  more  familiar  phraseology,  we  may  say  that  the 
rate  at  which  linen  exchanges  for  wheat  is  fixed  by  supply 
and  demand,  and  will  be  such  a  rate  that  the  supply  of 
wheat  offered  to  Ireland  by  Canada  is  equal  to  Ireland's 
demand  for  wheat;  otherwise  stated,  that  the  supply 
of  linen  offered  to  Canada  by  Ireland  shall  be  equal  to 
the  amount  demanded. 

1  The  general  principle,  in  fact,  even  when  actual  modern  trade  has  been  in 
view,  has  been  frequently  explained  by  economists  without  special  reference 
to  the  flow  of  money.  See,  for  example,  Mill,  Principles  of  Political  Economy, 
Book  III,  Ch.  XVIII,  §  2 ;  see  also  Bastable,  The  Theory  of  International  Trade, 
fourth  edition,  London  (Macmillan),  1903,  p.  27.  The  flow  of  money  has  then, 
as  in  Mill,  Ch.  XTX  of  Book  HI,  and  Bastable,  Ch.  Ill,  been  brought  under  the 
general  law. 


26     ECONOMIC  ADVANTAGES  OF  COMMERCE 

§3 

Effect  on  this  Rate,  when  One  of  the  Countries  Offers  a 
Variety  of  Goods  in  Trade,  and  also  when  it  Receives 
Periodic  Payments  of  Obligations  from  the  Other 

We  must  now  modify  our  hypotheses,  to  make  them 
conform  more  nearly  to  actual  conditions.  In  trade 
between  two  countries,  there  are  almost  certain  to  be 
more  than  two  commodities  or  services  involved.  Ire- 
land, to  recur  to  our  illustration,  will  probably  buy  other 
things  than  wheat  of  Canada,  possibly  furs,  timber, 
iron  ore,  etc. ;  while  Canada  is  likely  to  buy  other 
things  than  linen  of  Ireland.  Then,  even  if,  at  $i  per 
bushel  and  $i  per  yard,  respectively,  Ireland  wants  more 
wheat  than  Canada  does  linen,  money  does  not  neces- 
sarily flow  to  Canada,  changing  relative  prices  and  the 
gains  of  trade.  For  Canada's  desire  to  purchase  other 
Irish  goods  may  be  intense  enough  to  keep  the  relative 
distribution  of  money  and  the  relative  benefits  of  trade 
as  they  were. 

In  general,  we  may  say  that  the  more  varieties  of 
goods  a  country  can  offer  for  export,  the  better  is  its 
position  in  trade.1  England's  position,  for  example, 
is  better  if  it  produces  several  kinds  of  goods  for  foreign 
sale  than  if  it  produces  but  one.  The  demand  of  France 
or  Italy  or  other  countries  for  these  several  kinds  of 
goods  will  be  greater  than  for  any  one  thing  alone.  As 
a  consequence,  there  will  be  a  greater  tendency  for  gold 
to  flow  into  England,  making  English  prices  higher  and 
French,  or  other  prices,  lower,  so  giving  England  a 
larger  gain  from  the  trade.  The  more  largely  English 
merchants  and  manufacturers  can  introduce  English 

i  Mill,  Principles  of  Political  Economy,  Book  III,  Ch.  XVIII,  §  6. 


THE  RATE  OF  INTERCHANGE  OF  GOODS  27 

goods  into  favor  in  the  Orient,  in  Africa,  in  South  America, 
or  elsewhere,  the  greater  is  the  gain,  not  to  these  mer- 
chants and  manufacturers  alone,  but  to  the  English 
nation.  Among  the  goods  that  England  is  in  a  position 
to  offer,  must,  of  course,  be  included  banking  service, 
freight  service,  etc.,  as  well  as  commodities.  The  fact 
that  other  countries  desire  to  make  use  of  her  ships  is 
as  much  a  help  toward  making  trade  more  profitable 
to  England  as  the  fact  that  other  nations  desire  to  buy 
her  manufactures. 

In  a  similar  way,  England  is  helped  by  the  fact  that 
her  people  have  large  investments  abroad,  on  which 
they  receive  interest,  dividends,  etc.1  According  to 
the  principles  set  forth  in  Part  I,  Chapter  V,2  this  means 
flow  of  gold  to  England,  higher  prices  there,  lower  prices 
where  the  money  comes  from,  and,  consequently,  a 
flow  of  money  back  again  from  England.  In  the  long 
run,  England  receives  interest  in  the  form  of  goods 
rather  than  of  money.  The  money  tends  to  flow  back 
until  the  normal  equilibrium  is  restored.  But  if  Eng- 
land has  relatively  permanent  investments,  say  in 
the  United  States,  and  is  therefore  receiving  interest 
and  dividend  payments  from  the  United  States  for 
many  years  in  succession,  the  normal  equilibrium  of 
prices  probably  will  not,  during  all  that  time,  be 
reached.  As  fast  as  this  equilibrium  is  approached, 
further  interest  and  dividend  payments  upset  it. 
For  a  great  many  years,  therefore,  English  prices 
are  likely  to  be  somewhat  higher,  and  American 
prices  somewhat  lower,  than  would  be  the  case  if 
Americans  owed  nothing.  During  this  period,  then, 
England  will  get  somewhat  more  for  English  goods 

1  Taussig,  Principles  of  Political  Economy,  Vol.  I,  p.  499-  *  §  8- 


28    ECONOMIC  ADVANTAGES  OF  COMMERCE 

and  pay  somewhat  less  for  American  goods,  than 
otherwise.  The  rate  of  interchange  is  slightly  more 
favorable  to  England  than  it  would  otherwise  be. 
Even  assuming  all  trade  to  be  carried  on  in  the 
form  of  barter,  this  conclusion  would  still  hold  true. 
For  if  England  were  getting  continuous  interest  in 
American  goods,  English  desire  for  such  goods  would 
be  partly  satisfied,  their  utility  to  the  people  of  Eng- 
land would  be  less  (law  of  diminishing  utility),  and 
they  would  have  to  be  offered  at  a  less  value  in  terms 
of  English  goods.1 

On  the  other  hand,  England's  advantage  in  the  rate 
of  trade,  due  to  payments  of  interest,  etc.,  which  have 
to  be  made  to  Englishmen,  must  be  regarded  as  an  offset 
to  a  corresponding  disadvantage  in  the  rate  of  trade, 
during  the  period  when  the  investments  (on  which  in- 
terest, dividends,  etc.,  are  being  received)  were  made. 
During  the  period  when  England's  (or  any  country's) 
annual  investment  abroad  exceeded  her  annual  profits 
from  abroad,  the  tendency  was  for  gold  to  flow  from 
England  to  other  places.  This  tended  to  make  prices 
elsewhere  higher,  and  English  prices  lower,  to  give  other 
countries,  for  the  time  being,  a  more  favorable  rate  of 
interchange  of  goods  with  England.  A  country  whose 
people  are  making  large  investments  abroad,  then,  will 
have  to  dispose  of  its  goods,  for  the  time  being,  at  a  less 
favorable  rate;  but  it  will  later,  during  realization  of 

1  The  law  of  diminishing  utility  is  the  fundamental  explanation  of  England's 
gain  in  our  illustration,  even  if  money  is  used.  Were  it  not  for  the  law  of  dimin- 
ishing utility,  no  change,  or  no  appreciable  change,  in  relative  price  levels  would 
be  required  to  bring  about  the  flow  back,  for  goods,  of  the  money  paid  in  divi- 
dends, etc.  The  flow  back  would  begin  to  take  place  before  the  flow  of  money 
into  England  had  appreciably  changed  the  price  level  there  or  here,  and  would 
take  place,  therefore,  without  making  the  rate  of  interchange  of  goods  appre- 
ciably more  favorable  to  England. 


THE  RATE  OF  INTERCHANGE  OF  GOODS  29 

profits  and  repayment,  be  able  to  dispose  of  its  goods  at 
a  more  favorable  rate.1 

§4 

Influence  on  Trade  and  the  Rate  of  Trade  of  Production 
in  any  Country  under  Conditions  of  Different  Cost 

Up  to  this  point,  we  have  assumed  the  commodities 
entering  into  trade  to  be  produced  at  constant  cost  per 
unit,  regardless  of  the  amounts  produced.  But  such  is 
by  no  means  always  the  case.  Let  us  revert  to  the  in- 
stance of  Ireland  trading  with  Canada.  One  week's 
labor  in  Ireland  was  supposed  to  produce  6  bushels  of 
wheat.  As  a  matter  of  fact,  all  land  is  not  alike  in  fer- 
tility or  in  convenient  access  to  market.  While,  there- 
fore, it  might  be  true  that,  if  Ireland  produced  all  her 
own  wheat,  one  week's  labor  at  the  margin  of  cultiva- 
tion (that  is,  on  those  lands  least  favorable  to  wheat 
production  of  all  the  lands  so  used,  but  which  must  be 
devoted  to  wheat  production,  to  secure  an  adequate 
supply)  might  produce  but  6  bushels;  a  week's  labor 
in  other  parts  of  Ireland  would  perhaps  produce  a  great 
deal  more.  If  Ireland  produced  all  her  own  wheat,  the 
people  of  Ireland  would  have  to  produce  it,  perhaps,  on 
unfertile  lands  and  where  the  conditions  of  production 
were  relatively  unfavorable.  It  might,  therefore,  be 
uneconomical  for  Ireland  to  produce  her  own  entire 

1  Since  investment  is  really,  in  large  part,  a  purchase  of  capital  goods,  e.g. 
railways,  farms,  factories,  etc.,  it  may  be  asked  why  the  general  discussion  re- 
garding the  trade  of  the  goods  of  one  country  for  th$  goods  of  another  does  not 
cover  investment  also.  But  investment  is  rather  the  purchase  of  rights  in  goods 
which  are  not  themselves  moved.  The  capital  purchased  remains  in  the  foreign 
country  and  yields  future  income  to  the  distant  investors.  This  yielding  of 
future  income,  involves  a  later  and  opposite  influence  on  the  rate  of  trade  be- 
tween the  countries,  which  does  not  occur  when  the  owners  and  the  capital  owned 
are  in  the  same  place.  Hence,  special  consideration  must  be  devoted  to  the 
effects  of  lending  and  investing,  on  trade. 


30     ECONOMIC  ADVANTAGES  OF  COMMERCE 

supply  of  wheat.  Some  wheat  should  rather  be  imported 
from  Canada.  But  it  might  well  be  profitable  for  the 
people  of  Ireland  to  employ  some  of  their  more  fertile 
land,  if  not  better  situated  and  adapted  for  other  crops, 
in  wheat  production.1  The  possession  of  this  more 
fertile  land  would  lessen  the  intensity  of  Ireland's  demand 
for  Canadian  wheat,  and  would  thus  tend  to  make  the 
rate  of  trade  between  the  countries  more  favorable 
to  Ireland  than  if  her  entire  supply  of  wheat  had  to  be 
secured  from  abroad.  If  linen  sells  for  $i  a  yard  and 
Canadian  wheat  is  $i  a  bushel,  then  it  is  of  course  more 
profitable  for  Ireland  to  buy  Canadian  wheat  than  to 
produce  wheat  on  poor  Irish  land,  under  intensive  culti- 
vation (i.e.  with  but  small  areas  of  land  for  each  unit  of 
labor),  where  a  week's  labor  can  only  produce  6  bushels, 
and  where  it  can  only  be  remunerated  by  a  price  of  $1.67 
a  bushel.  But  it  would  be  profitable  for  Ireland  to  pro- 
duce wheat  for  home  consumption  on  land  where  a 
week's  labor  would  yield  14  or  13  or  down  to  10  bushels, 
unless  this  land,  or  part  of  it,  was  so  situated  and  adapted 
as  to  yield  still  more  from  some  other  use,  e.g.  from  being 
used  to  raise  potatoes.  A  yield  of  10  bushels  a  week 
would  require  only  $i  a  bushel  (linen  being  $i  a  yard), 
to  induce  wheat  production  in  Ireland,  and  so  to  raise 
the  wheat,  would,  by  our  hypothesis,  be  as  economical 
as  to  import  it  from  Canada.  On  land  yielding  7,  8,  9, 
or  less  than  10  bushels  a  week,  wheat  production  in  Ire- 
land is  uneconomical  as  long  as  a  yard  of  linen  cloth  will 
buy  from  Canada  a  bushel  of  wheat.  So  it  results  that, 
because  of  the  law  of  diminishing  returns,  it  is  often  most 
profitable  for  a  country  to  produce,  in  part,  its  desired 
supply  of  some  commodity,  and  import  the  rest.  If  the 

1  Bastable,  Theory  of  International  Trade,  pp.  29  and  30. 


THE  RATE  OF  INTERCHANGE  OF  GOODS  31 

demand  for  wheat  in  Ireland  became  greater,  poorer 
Irish  sources  of  production  would  perhaps  be  resorted 
to  for  a  small  part  of  the  supply,  while  somewhat  more 
would  be  imported  from  Canada  and  elsewhere  at  the 
higher  price,  relative  to  linen  cloth,  resulting  from  this 
greater  demand. 

By  similar  reasoning  it  may  be  shown  that  beyond  a 
certain  point  of  high  cost,  wheat  production  in  Canada 
for  export  would  not  be  carried,  but  that  the  people  of 
Canada  would  prefer  to  devote  themselves,  in  part,  to 
other  work,  even  to  the  manufacture  of  linen.  Cana- 
dians would  not  carry  wheat  production  to  land  so  poor 
(assuming  a  great  increase  in  population)  as  to  yield 
less  than  14  bushels  a  week,  so  long  as  14  yards  of  linen 
could  be  produced  in  a  week's  labor;  for,  beyond  that 
point,  it  would  pay  better  to  produce  linen  at  $i  a  yard 
than  wheat  at  $i  a  bushel.  Growing  density  of  popu- 
lation tends,  in  general,  to  the  spread  of  manufacturing, 
because  employment  in  agriculture,  after  a  certain  degree 
of  intensiveness  of  cultivation  has  been  reached,  becomes 
less  profitable  at  the  margin  the  more  persons  are 
engaged  in  it. 

It  has  been  the  good  fortune  of  the  American  people 
that  they  have  lived  in  a  country  not  overpopulated 
and  one  of  very  considerable  natural  resources.  They 
have  had  always,  therefore,  the  opportunity  to  engage 
in  the  extractive  industries,  particularly  in  agriculture, 
and  realize  large  returns  in  so  doing.  They  have  not 
had  to  take  up  manufacturing,  however  small  the  profits, 
merely  for  the  lack  of  a  profitable  alternative,  though 
they  have  found  it  worth  while  to  engage  in  various 
lines  of  manufacturing  industry  which  American  re- 
sources or  American  methods  make  especially  productive 


32     ECONOMIC  ADVANTAGES  OF  COMMERCE 

in  the  United  States.  If  other  countries,  such  as  Eng- 
land and  Germany,  are  forced  by  dense  populations 
and  limited  resources  to  engage  in  manufacturing  to  a 
greater  relative  degree,  Americans  have,  on  that  account, 
no  reason  for  envy,  nor  any  reason  for  attempting, 
through  tariffs  or  other  arbitrary  interferences,  to  force 
American  industry  more  largely  into  parallel  channels. 

§s 

Extension  of  Hypothesis  so  as  to  Include  Trade  Involving 
More  than  Two  Countries 

As  we  broadened  our  first  hypothetical  conditions 
so  as  to  include  more  than  two  kinds  of  goods,  we  shall 
now  further  broaden  them  so  as  to  consider  more  than 
two  trading  communities.  We  have  assumed  Ireland 
and  Canada  to  be  engaged  in  trade  with  each  other. 
But  trade  may  be  three-cornered  or  four-cornered  or 
more.  Ireland  may  sell  its  linen  chiefly  to  the  United 
States  instead  of  to  Canada ;  the  United  States  may  sell 
cotton  to  Canada ;  and  Canada  may  in  turn  export  wheat 
to  Ireland.  Under  these  circumstances,  the  rates  of 
interchange  would  still  depend  on  relative  intensities 
of  demand.  The  rate  at  which  Ireland  can  exchange 
linen  for  wheat,  depends  on  the  price  which  can  be  re- 
alized, in  the  United  States,  for  linen,  and  the  price  which 
must  be  paid,  in  Canada,  for  wheat,  or  upon  the  intensity 
of  American  demand  for  the  linen  compared  to  the  in- 
tensity of  Irish  demand  for  the  wheat.  The  American 
demand  for  the  linen,  at  any  price,  will  depend,  in  part, 
on  what  Americans  can  get  for  cotton.  The  Canadian 
demand  for  cotton  will  depend,  in  part,  on  what  Cana- 
dians can  get  for  wheat.  If  Ireland  has  a  surplus  de- 


THE  RATE  OF  INTERCHANGE  OF  GOODS  33 

mand  for  wheat  at  $i  a  bushel,  gold  will  flow  to  Canada 
and  Canadian  prices  will  rise.  Canadians  may  then 
buy  more  cotton,  in  which  case  American  prices  will 
rise.  Irish  prices  will  fall,  and  Americans  will  probably 
buy  more  linen.  When  equilibrium  is  reached,  Ireland 
will  be  paying  somewhat  more  for  wheat  and  getting 
somewhat  less  for  linen.  The  United  States  will  prob- 
ably be  getting  somewhat  more  for  cotton  and  will  be 
paying  somewhat  less  for  linen.  Canada  or  the  United 
States  or  both  will  gain  more  from  the  trade,  and  Ire- 
land will  gain  less.  As  in  trade  between  two  countries, 
equilibrium  will  be  reached  at  a  set  of  relative  prices 
or  values  which  equalizes  supply  and  demand. 

How  are  the  commercial  interests  of  three  nations 
affected  by  the  entrance  of  the  third  into  trade  with 
the  other  two?  The  general  effect  will  be  an  increase 
of  prosperity,  and  it  is  entirely  possible  that  each  of  the 
three  countries  will  gain  something.  Suppose,  to  take 
a  seemingly  most  unfavorable  case,  that  France  enters  a 
trade  previously  confined  to  Ireland  and  Canada,  as  a 
competitor  of  Ireland,  competing  with  the  last-named 
country  in  the  sale  of  linen  to  Canada  and  in  the  purchase 
of  wheat  from  Canada.  In  so  far  as  France  engages 
in  this  trade  and  no  other,  Ireland  is  deprived  of  a  part 
of  her  former  gain ;  but  there  is  no  net  loss,  for  France 
and  Canada  together  gain  as  much  as  Ireland  loses,  or 
more.  In  consequence  of  the  competition  of  France, 
linen  will  fall  in  price,  or  wheat  will  rise,  or  both,  so  that 
a  yard  of  linen  buys  less  wheat  than  before.  So  far  as 
Ireland  still  engages  in  the  trade,  at  the  new  and,  to  her, 
more  unfavorable  rate  of  interchange,  Canada  gains, 
besides  her  former  profit,  precisely  what  Ireland  has 
ceased  to  gain.  So  far  as  Ireland  is  driven  out  of  the 

PART  II  —  D 


34     ECONOMIC  ADVANTAGES  OF  COMMERCE 

trade  by  the  entrance  of  France,  France  gains  at  least 
as  much  trade  as  Ireland  loses,  though  at  a  rate  of  in- 
terchange somewhat  more  profitable  to  Canada  and 
somewhat  less  so  to  France,  than  would  be  necessary 
were  Ireland's  competition  absent.  So  far  as  France  loses 
through  the  less  favorable  rate  of  interchange  caused 
by  Ireland's  competition,  Canada  gains.  If  the  result 
of  the  competition  is  a  larger  trade  for  Canada  with  the 
other  two  countries  than  Canada  previously  had  with 
the  one,  as  well  as  a  more  favorable  rate,  then  Canada 
gains  more  than  either  of  the  others  loses  or  than  both 
lose;  for  Canada's  greater  gain  on  the  same  trade  as 
before,  at  the  better  rate,  makes  up  for  the  lessened  gain 
of  the  other  or  others ;  while  the  additional  trade,  which 
must  be  at  least  worth  having  to  the  other  country  or 
countries,  else  it  or  they  would  not  trade,  is  a  very  consid- 
erable gain  to  Canada.  The  competing  countries,  there- 
fore, though  they  may  hurt  each  other,  will  benefit  by 
at  least  as  much,  and  probably  by  more,  the  country  or 
countries  for  whose  trade  they  compete. 

If,  now,  besides  competing  against  Ireland  in  the  trade 
with  Canada,  France  also  enters  into  trade  with  Ireland, 
both  Ireland  and  France  may  gain  from  this  trade  as 
much  as,  or  more  than,  they  are  losing  by  their  competi- 
tion. Then  the  entering  of  France  into  trade  relations 
with  the  other  two  countries  will  benefit  Canada,  Ire- 
land, and  France.  It  seems  a  perfectly  fair  statement, 
therefore,  that  the  more  widely  trade  is  voluntarily, 
and  without  governmental  encouragement,  extended,  i.e. 
the  more  countries  enter  into  it,  the  greater  is  the  total 
gain;  and  that  there  is  reasonable  hope  for  a  greater 
net  gain  to  all  countries  concerned.  In  no  case  can 
the  entrance  of  an  additional  country  or  community 


THE  RATE  OF  INTERCHANGE  OF  GOODS  35 

cause  a  country  or  community  already  engaged  in  a  trade, 
to  engage  thereafter  in  a  losing  trade.  It  has  already 
been  explained  that  unless  a  trade  yields  a  gain  to  both 
(as,  of  course,  to  all,  if  more  than  two)  countries  con- 
cerned, the  trade  will  not  take  place.  The  most  that 
the  new  competition  can  do  is  to  decrease  this  gain  for 
the  country  or  countries  on  one  side  of  the  trade.  And, 
as  above  pointed  out,  the  countries  which  lower  each 
other's  gains  by  competition  for  the  trade  of  a  third 
country,  may  increase  each  other's  gains  by  trade  with 
each  other. 

Any  country  gains  more,  the  more  numerous  the  other 
countries  which  desire  its  products  and  the  more  nu- 
merous the  other  countries  which  have  goods  to  offer  it. 
On  the  other  hand,  the  competitive  entering  of  many 
countries  into  trade  makes  it  impossible  for  any  one 
country  to  gain  so  extreme  a  share  of  the  advantage  in 
trade  with  another  as  otherwise  it  might.  The  one 
country  will  seldom  have  a  monopoly  of  the  production 
of  goods  needed  in  the  other  and  will  seldom  be  the  only 
place  where  the  other  can  sell  its  products.  Alternative 
markets  will  generally  be  available,  and  the  gains  of 
trade  are  therefore  likely  to  be  more  nearly  equal  between 
two  trading  countries.  It  is  for  these  reasons  that  the 
policy  of  European  nations,  in  early  colonial  days,  of 
restricting  the  trade  of  colonies  with  other  than  their 
respective  mother  countries,  might  be  advantageous 
to  the  mother  countries,  but  was  at  the  same  time  dis- 
advantageous to  the  colonies. 


36     ECONOMIC  ADVANTAGES  OF  COMMERCE 

§6 

Cost  of  Transportation  as  Related  to  Trade 

Cost  of  transportation  is  a  factor  influencing  trade, 
which  must  be  considered  before  our  discussion  is  com- 
plete. This  cost  subtracts  from  the  gains  of  trade  the 
amount  necessary  to  remunerate  those  engaged  in  carry- 
ing the  goods.  The  principles  determining  how  much 
gain  is  realized  by  each  country  are,  of  course,  unaffected. 
Trade  which  cannot  yield  enough  to  pay  for  transporta- 
tion simply  does  not  take  place,  unless  it  is  artificially 
stimulated,  as  by  government  bounties. 

§7 

Summary 

In  this  chapter  we  have  confined  our  attention  almost 
entirely  to  the  rate  of  interchange  of  goods  between 
trading  communities  and  countries.  We  have  seen  that, 
in  the  case  of  trade  between  any  two  countries,  the  rate 
at  which  the  goods  of  the  one  exchange  for  the  goods  of 
the  other  cannot  lie  beyond  either  of  two  limits,  at  the 
one  of  which  the  one  country,  and  at  the  other  of  which 
the  other  country,  gains  nothing  from  the  trade.  Be- 
tween these  limits,  the  exact  rate  is  fixed  by  the  com- 
parative intensity  of  demand  of  each  country  for  the 
goods  of  the  other,  or,  to  use  familiar  terms,  by  supply 
and  demand.  Whether  gold  is  a  common  standard  of 
value,  or  the  currencies  unrelated,  or  the  trade  direct 
barter  of  goods  for  goods,  the  rate  of  interchange  will 
be  fixed  where  intensities  of  demand  balance. 

A  country  is  the  more  likely  to  get  a  large  share  of 
the  total  gain  resulting  from  its  trade  with  another 


THE  RATE  OF  INTERCHANGE  OF  GOODS  37 

country  or  countries,  the  greater  the  variety  of  goods 
it  can  offer  to  stimulate  the  desire  of  the  other  country 
or  countries  to  trade.  In  like  manner,  a  country  to 
which  payments  have  to  be  made  by  other  countries, 
e.g.  of  interest  and  dividends,  is  in  a  position  to  get,  in 
consequence,  more  favorable  rates  of  interchange,  though 
such  a  country  may  have  had,  previously,  during  the 
period  of  its  investing  operations,  somewhat  less  favor- 
able rates. 

The  assumption  first  made  that  each  country  would 
buy  of  the  other  the  goods  securable  most  cheaply  from 
the  other,  was  explained  and  qualified  to  conform  with 
the  fact  of  differing  cost  of  production  of  any  good,  within 
the  same  country.  It  was  pointed  out  that  a  country 
might  produce  for  itself  a  certain  amount  of  a  desired 
kind  of  goods,  from  its  most  favorable  sources  of  supply, 
or  up  to  the  point  where  further  home  production  would 
involve  uneconomical  employment  of  its  labor  and  capi- 
tal ;  and  that  beyond  that  point  it  would  import. 

Our  assumptions  were  further  broadened  to  include 
trade  involving  more  than  two  countries.  Three-cor- 
nered trade  was  alluded  to,  and  it  was  shown  that  the 
influence  of  comparative  intensity  of  demand  is  of  deter- 
mining force  in  this  case  and  likewise  in  cases  involving 
still  more  countries.  If  a  third  country  (or  a  fourth 
or  fifth)  enters  into  a  trade  previously  confined  to  two 
countries  (or  three  or  four),  the  result  will  be  a  greater 
total  prosperity,  although  if  the  third  country  enters 
the  trade  only  as  a  competitor  of  one  of  the  others,  that 
one  may  find  its  gains  somewhat  reduced.  If  each  trades 
with  each  of  the  others,  there  is  a  reasonable  prospect 
for  increased  prosperity  to  all  three.  Any  country, 
however,  is  prevented  by  the  entrance  of  other  countries 


38      ECONOMIC  ADVANTAGES  OF  COMMERCE 

into  competition  with  it  from  realizing  exorbitant 
profits  at  the  expense  of  the  countries  it  trades  with. 
On  the  other  hand,  any  country  gains  the  more  from 
trade,  the  larger  the  number  of  other  countries  which 
compete  with  each  other  in  buying  from  and  selling  to  it. 


CHAPTER  III 
THE  INCIDENCE  OF  TARIFFS  FOR  REVENUE 

§i 

Revenue  and  Protective  Tariffs  Distinguished 

So  far  we  have  discussed  international  trade  mainly 
on  the  assumption  that  such  trade  is  wholly  free.  As  a 
matter  of  fact,  trade  is  almost  never  wholly  free  between 
nations,  though  it  is  frequently  so  within  the  boundaries 
of  a  single  nation.  One  of  the  largest,  if  not  the  largest, 
of  free  trade  areas  in  the  world,  is  the  United  States. 
Between  one  state  and  another,  any  tariff  is  unconsti- 
tutional. We  have,  therefore,  free  trade  within  our 
own  borders,  though  not  with  outside  nations.  Almost, 
if  not  quite,  every  nation  has  a  tariff  wall,  high  or  low 
as  the  case  may  be,  which,  usually,  to  a  greater  or  less 
extent,  hampers  trade.  Tariff  duties  at  the  boundaries 
of  a  country  may  be  levied  on  goods  imported  or  on  goods 
exported,  but  in  practice  are  much  more  likely  to  be 
levied  on  the  former.  We  shall  consider  the  economic 
effects  of  both  import  and  export  duties. 

Import  duties  are  of  two  sorts,  revenue  tariffs  and 
protective  tariffs.  A  strict  revenue  tariff  is  intended 
to  raise  revenue,  while  not  interfering  with  trade  more 
than  is  necessary.  Although  absolute  free  trade  practi- 
cally never  exists  between  great  nations,  yet,  in  ordinary 
usance,  free  trade  is  said  to  exist  when  the  tariff  levied 
is  levied  according  to  strict  revenue  principles.  A 
strictly  revenue  tariff,  or  so-called  "free  trade,"  means, 

39 


40      ECONOMIC  ADVANTAGES  OF  COMMERCE 

then,  such  an  adjustment  of  taxes  as  will  not,  in  any 
great  degree,  divert  industry  in  the  levying  country  out 
of  the  channels  it  would  otherwise  follow,  i.e.  it  will 
so  divert  industry  to  the  least  possible  extent  consistent 
with  collection  of  the  needed  revenue.  A  tariff  levied 
by  any  country  only  on  goods  not  produced  within  it, 
is  such  a  tariff.  An  example  is  the  British  import  tax 
on  tea,  an  article  not  produced  in  Great  Britain  or  Ire- 
land. An  import  duty  on  goods  which  are,  or  can  be, 
produced  within  the  levying  country,  is  also,  properly 
speaking,  a  revenue  duty,  if  it  is  accompanied  by  an 
internal  tax  of  equal  amount l  on  the  domestic  product. 
Such  a  tax  does  not  have,  and  is  not  intended  to  have, 
any  great  effect  on  the  location  of  industry.  If  the 
domestic  producer  is  helped  by  the  tax  levied  on  imported 
goods,  he  is  hindered  to  an  approximately  equal  extent 
by  the  tax  laid  upon  his  own  goods.2  His  position  in 
relation  to  that  of  his  foreign  rivals  remains,  therefore, 
substantially  the  same  as  before. 

A  protective  tax  is  intended,  as  such,  primarily  to 
divert  industry  from  the  channels  it  would  otherwise 
follow  into  channels  favored  and  encouraged  by  the 
tariff  law.  Its  purpose  is  to  encourage  the  home  pro- 
ducer in  some  line  or  lines  by  levying  a  high  tax  on 
goods  brought  from  abroad  and  thus  discouraging  the 
importation  of  such  goods. 

1  If  the  domestic  goods  are  of  identical  grade  and  therefore  of  the  same  value, 
a  tax  of  the  same  per  cent  is  also  a  tax  of  the  same  amount  per  unit  of  quantity. 
If  the  domestic  goods  are  of  different  grade  and  different  value,  the  question 
might  arise  whether  a  per  cent  tax  or  a  tax  per  unit  should  be  levied  equally  on 
both. 

2  Of  course  the  tax,  by  necessitating  a  higher  price,  may  decrease  the  total 
demand.    If  so,  both  home  and  foreign  producers  may  make  smaller  sales.     But 
so  far  as  the  public  still  buys  the  goods,  these  goods  are  produced  where  the  condi- 
tions are  relatively  the  best. 


THE  INCIDENCE  OF  TARIFFS  FOR  REVENUE    41 

Expressing  the  matter  in  another  way,  we  may  say 
that  both  the  revenue  and  the  protective  tariff  are  taxes 
on  the  consumer ;  but  that  in  the  former  case  the  con- 
sumer pays  this  tax  to  the  government,  while  in  the 
latter  he  pays  a  tax  to  the  home  producer.  A  revenue 
tariff  on  imports  can  only  be  successful  in  its  chief  aim 
if  it  allows  goods  to  be  imported,  because  on  all  such 
goods  a  tax  is  paid  which  goes  to  the  government  and 
may  be  used  for  public  purposes;  while,  on  the  other 
hand,  a  protective  tariff  is  most  successful  in  its  aim 
in  so  far  as  it  prevents  goods  from  being  imported,  be- 
cause then  its  effect  is  to  raise  the  price  which  the  home 
producers  can  charge.  In  this  latter  case,  the  govern- 
ment gets  little  or  no  revenue,  and  the  tax,  if  we  call 
it  such,  which  the  consumer  pays,  is  paid,  in  the  main, 
to  the  home  producers,  rather  than  to  the  government. 
In  other  words,  the  protective  tariff  makes  the  consumer 
buy  of  the  home  producer  at  prices  higher  than  the  home 
producer  could  otherwise  charge. 


When  the  Burden  of  an  Import  Duty  Levied  for  Revenue 
is  Borne  by  the  Levying  Country 

A  revenue  import  duty  is  commonly  supposed  to  be 
shifted  by  the  importers  on  whom  it  is  first  imposed,  to 
the  consumers,  in  the  levying  country,  of  the  taxed  goods. 
In  the  complications  of  modern  trade,  with  many  coun- 
tries taking  part,  this  result  is  perhaps  very  nearly 
realized.  But  it  is  perhaps  never  exactly  realized,  and 
it  is  not  difficult  to  imagine  circumstances  under  which 
the  main  burden  of  the  tax  would  fall  elsewhere  than 
on  the  consuming  public  of  the  tariff  levying  country. 


42      ECONOMIC  ADVANTAGES  OF  COMMERCE 

Under  sufficiently  favorable  (to  the  levying  country) 
circumstances,  a  part,  or  all,  of  the  tax  might  fall  upon 
the  exporting  country,  or,  conceivably,  the  exporting 
country  might  lose  more  than  the  tax,  to  the  profit  of 
the  levying  country. 

Let  us,  in  discussing  the  various  possible  shif tings  of 
an  import  revenue  duty,  use  again  our  familiar  illus- 
tration, the  assumed  trade  between  Ireland  and  Canada. 
If  Canada,  where  a  week's  labor  will  produce,  according 
to  our  first  assumptions,  20  bushels  of  wheat  at  $i  a 
bushel  or  14  yards  of  linen  at  $1.43  a  yard,  levies  an 
import  duty  of  10  cents  a  yard  on  linen  from  Ireland, 
which  would  otherwise  sell  for  $i  a  yard,  this  linen  will 
sell  for  $1.10.  Irish  linen  will  still  be  bought  by  Cana- 
dians in  preference,1  since  Canadian  linen  cannot  be 
sold  for  less  than  $1.43.  The  tax  is  levied  first  on  the 
importers.  The  importers  will  not,  perhaps  cannot, 
remain  in  business  if  they  are  unable  to  shift  the  tax, 
for  to  pay  it  themselves  will  make  their  profits  (if  these 
have  been  subject  to  competition  and  are  therefore 
approximately  the  same  as  in  other  kinds  of  business) 
less  than  the  same  labor  and  capital  will  yield  in  other 
lines,  and  will  very  likely  even  turn  them  into  losses. 
The  foreign  producers  will  not  (unless  combined  in  a 
monopoly  and  previously  earning  monopoly  profits, 
and  not  then  except  under  very  improbable  circum- 
stances 2)  consent  to  suffer  the  loss,  since  this  will  reduce 

1  If  there  is  any  likelihood  that  such  will  not  be  the  case,  and  if  the  tariff  is 
to  be  levied  for  revenue,  not  for  protection,  a  tax  as  great  should  be  placed  on 
the  home  produced  goods. 

2  I.e.  if  the  monopoly  will  lose  less  to  bear  the  whole  tax  than  to  shift  it  and  suf- 
fer a  reduction  of  its  sales.    A  monopoly  will  itself  pay,  without  trying  to  shift, 
a  tax  levied  directly  on  monopoly  profits,  since  the  monopoly  can  best  pay  such  a 
tax  by  maintaining  the  same  prices,  i.e.  prices  yielding  the  highest  net  return. 
But  a  tax  which  increases  in  proportion  to  the  number  of  sales,  a  monopoly  will 


THE  INCIDENCE  OF  TARIFFS  FOR  REVENUE    43 

their  profits  below  the  average  level  in  their  country,  , 
in  other  lines.    The  supply  of  Irish  linen  offered  in 
Canada  will  not,  therefore,  equal  the  demand,  unless 
the  price  rises  by  10  cents  a  yard. 

If  the  demand  of  Canada  for  linen  is  absolutely  in- 
elastic, the  shifting  proceeds  no  further;  the  10  cents 
a  yard  remains  as  a  continuing  burden  on  Canadian 
consumers  of  linen.  A  certain  amount  of  linen  was 
wanted  at  the  former  and  lower  price,  and  the  same 
amount  is  wanted  at  the  somewhat  higher  price.  The 
10  cents  additional  goes  to  the  Canadian  government. 
The  same  amount  as  before  must  be  paid  to  linen  manu- 
facturers in  Ireland.  Canadian  wheat  prices  will  not 
change,  and  wheat  consumers  in  Ireland  will  buy  the 
same  amount  as  before  of  Canadian  wheat.  The  trade 
will  be  in  equilibrium  at  just  the  same  point,  as  to  quan- 
tity of  money  in  each  country  and  as  to  amount  of  cloth 
required  to  buy  a  bushel  of  wheat,  as  before.  The  net 
result  is  to  take  10  cents  a  yard  from  each  Canadian 
purchaser  of  linen  imported  from  Ireland,  and  transfer 
this  10  cents  to  his  government.  If  we  omit  reference 
to  money  and  money  prices,  we  may  say  that  the  tax 
has  left  just  where  it  was  before,  the  rate  of  interchange 
between  the  two  commodities,  linen  and  wheat,  which 
equalized  supply  of  and  demand  for  each  in  terms  of 
the  other ;  and  that  the  Canadian  government  has  sim- 
ply taken  in  taxation,  from  its  own  subjects,  a  part  of 
their  gain  from  the  trade. 

be  more  likely  to  endeavor  to  shift,  and  will  not  so  greatly  fear  a  resulting  de- 
crease of  its  sales,  since  this  involves  a  decreased  tax  also. 


44     ECONOMIC  ADVANTAGES  OF  COMMERCE 


When  the  Burden  of  an  Import  Duty  Levied  for  Revenue 
is  Shifted  by  the  Levying  Country  to  Another  or  to 
Other  Countries 

But  the  situation  is  otherwise  if  Canada's  demand 
for  Irish  linen  is  elastic  while,  at  the  same  time,  Ireland's 
demand  for  Canadian  wheat  is  inelastic.  If  the  demand 
of  Canada  for  linen  imported  from  Ireland  is  elastic, 
then  the  effect  of  the  ten  cents  tax,  in  raising  the  price 
of  the  linen  to  $1.10  a  yard,  will  be  to  decrease  the  Cana- 
dian demand  for  the  linen.  In  consequence,  Canada 
will  have  a  smaller  money  obligation  to  Ireland.  Yet  if 
Ireland  continues  to  buy  as  much  wheat  as  before,  the 
yearly  money  obligations  from  Ireland  to  Canada  will 
be  the  same  as  if  the  tax  were  not  in  force.  There  will 
consequently  be  an  excess  flow  of  money  to  Canada. 
Canadian  prices  will  rise  and  Irish  prices  will  fall.  Of 
course,  if  the  Irish  demand  for  wheat  is  elastic,  or  if 
Ireland  can  as  cheaply  buy  her  wheat  elsewhere,  Ire- 
land's demand  for  wheat  will  fall  off  as  soon  as  the  price 
rises  very  slightly.  Then  there  can  be  little  redistribu- 
tion of  the  money  metal,  and  Canada  can  shift  very 
little  of  the  tax  upon  Ireland.  The  net  result  is  less 
trade.  Canadians  buy  less  cloth  and  sell  less  wheat. 
But  if  the  Irish  demand  for  Canadian  wheat  is  inelastic, 
continuing  at  about  the  same  amount  despite  rise  of 
prices,  then  the  tax  may  seriously  decrease  Ireland's 
gain  from  the  trade,  to  Canada's  advantage. 

To  illustrate  this  possibility,  let  us  suppose  that,  in 
consequence  of  the  tax  on  linen  of  ten  cents  a  yard, 
which  raises  4he  price  to  Canadian  consumers,  the  de- 
mand for  linen  is  so  decreased  in  Canada  that  there  is 


THE  INCIDENCE  OF  TARIFFS  FOR  REVENUE    45 

a  net  inflow  of  gold  from  Ireland ;  and  let  us  suppose, 
further,  that  the  inflow  of  gold  does  not  cease  until  the 
supply  of  money  in  Canada  is  jf  of  its  former  amount, 
and  that  of  Ireland  •£$  of  what  it  was.  Then  Cana- 
dian wheat  would  sell  for  ^f  of  $i  or  about  $1.09 
a  bushel,  while  Irish  linen,  not  counting  the  tax,  would 
sell  for  $0.90  instead  of  $i  per  yard,  or,  with  the  ten 
cents  tax,  at  $i  instead  of  $1.10.  Let  us  suppose  that, 
at  this  new  set  of  prices,  Canada  again  has  to  pay  Ire- 
land as  much  for  linen  each  year  as  Ireland  has  to  pay 
Canada  for  wheat. 

How  does  the  case  stand  as  to  gains  and  losses  of 
the  two  communities  ?  The  Canadians  are  still  getting 
their  linen  for  $i  a  yard,  the  price  without  the  tax  hav- 
ing fallen  to  $0.90.  And  they  are  getting  $1.10  a  bushel 
for  wheat  instead  of  $i.  The  Canadian  government 
is  securing  its  ten  cents  tax  on  every  yard  of  linen ;  yet 
Canadian  consumers  are  paying  no  more  than  before 
the  tax  was  laid,  and  Canadian  producers  are  getting 
a  higher  price  for  their  wheat.  The  people  of  Ireland 
are  paying  to  Canada  the  tax  and  more  than  the  tax.1 
The  linen  manufacturing  interests  of  Ireland  are  receiv- 
ing $0.90  instead  of  $i  a  yard  for  their  linen;  they 
are  paying  more  for  wheat.  It  is  still  worth  while  for 
them  to  engage  in  the  trade.  They  can  still  secure  more 
wheat  in  exchange  for  a  week's  production  of  linen  than 
they  can  themselves  produce  in  a  week  (except  on  their 
best  lands).  But  they  gain  much  less  from  the  trade 
than  formerly.  It  should  be  added  that  the  taxing 
country,  Canada,  may  gain  also  in  lower  prices  of  other 
Irish  goods  than  linen  cloth,  resulting  from  the  redis- 
tribution of  money,  and  in  their  ability  to  buy  more  of 

i  Mill,  Principles  of  Political  Economy,  Book  V,  Ch.  IV,  §  6. 


46     ECONOMIC  ADVANTAGES  OF  COMMERCE 

these  goods  because  of  the  lower  prices  and  their  own 
higher  incomes. 

We  must  guard  ourselves  against  the  assumption  that 
the  whole  loss  falls  upon  the  Irish  linen  manufacturing 
population  as  distinguished  from  Irish  producers  in 
other  lines.1  The  loss  is  general.  The  linen  producers 
would  not  remain  in  that  business  and  alone  bear  all 
the  loss,  since  labor  and  capital  tend  always  to  leave 
relatively  unprofitable  for  relatively  profitable  activities. 
They  only  sell  linen  more  cheaply  because  of  a  decrease 
of  money  in  Ireland,  which  tends  to  lower  in  a  like  pro- 
portion the  prices  of  all  Irish  goods  and  Irish  labor.2 
Likewise,  the  higher  price  of  Canadian  wheat  falls  alike 
on  all  consumers  of  it  in  Ireland. 

On  one  hypothesis,  however,  the  price  of  linen  made 
in  Ireland  would  fall  by  a  greater  per  cent  than  other 
Irish  prices,  viz.  on  the  hypothesis  (likely  to  be  in  con- 
formity with  fact)  that  the  profits  of  linen  production 
are  greater  in  some  factories  and  on  some  sites  in  Ire- 
land than  on  other  sites  in  that  country.  If  the  tax 
decreases  the  demand  for  the  linen  in  Canada,  the  Irish 
manufacturers  on  the  better  sites  may  alone  be  able 
to  satisfy  the  demand  remaining;  and  they  may  be 
willing  to  do  so,  because  of  their  relatively  advanta- 

1  Mill,  Principles  of  Political  Economy,  Book  V,  Ch.  IV,  §  6. 

2  Strictly  speaking,  a  A  decrease  of  money  in  Ireland  would,  under  the  con- 
ditions here  assumed,  cause  a  fall  in  the  prices  of  Irish  goods,  of  more  than  &. 
For  it  would  cause  a  fall  of  A  in  average  prices,  including  the  price  of  Canadian 
wheat  and  its  products  so  far  as  bought  and  sold  in  Ireland,  e.g.  by  middlemen. 
Since  these  goods  would  be  higher  in  price,  other  goods  must  fall  in  greater  pro- 
portion than  10  per  cent.     Whether  the  fall  in  the  prices  of  other  goods  would 
be  much  greater  than  10  per  cent,  would  depend  upon  the  importance,  in  the 
Irish  market,  of  the  Canadian  product.     If  trade  with  Canada  is  assumed  to 
be  of  slight  importance,  other  prices  would  fall  by  about  A,  otherwise  by  more. 
But  no  good  purpose  would  be  served  by  complicating  the  text  with  these  re- 
finements. 


THE  INCIDENCE  OF  TARIFFS  FOR  REVENUE    47 

geous  positions,  at  prices  lower  than  could  be  afforded 
by  marginal  manufacturers  (e.g.  those  on  the  poorest 
sites),  rather  than  go  into  other  occupations.  The  loss 
to  Ireland,  due  to  Canada's  tax,  would  then  fall  with 
greatest  weight  on  the  linen  producers  of  Ireland,  or 
on  the  owners  of  sites  adapted  to  linen  manufacture. 
A  surplus  gain,  from  better  organization  or  from  more 
advantageous  situation,  which  these  classes  had  pre- 
viously enjoyed,  would  be  lessened. 

As  regards  the  ultimate  burden  of  the  tax,  we  reach 
no  different  conclusion  if  we  assume  the  currencies  of 
Ireland  and  Canada  to  be  based  on  independent  standards 
and  prices  in  the  one  country  to  be  entirely  unrelated 
to  prices  in  the  other.1  Suppose  each  to  have  a  paper 
money  standard,  not  redeemable  in  gold.  The  ten 
cents  tax  discourages  Canadian  purchase  of  Irish  linen. 
Ireland  continues  to  buy  about  the  usual  amount  of 
Canadian  wheat.  The  balance  is  settled  in  gold.  In 
Ireland,  gold  becomes  scarcer  and  has  more  purchasing 
power;  in  Canada,  it  becomes  more  plentiful  and  has 
less  purchasing  power,  per  unit  quantity.  Irish  paper 
money  will  buy  less  gold.  Canadian  paper  money  will 
buy  more  gold.  Canadian  wheat  remains  $i  a  bushel 
in  terms  of  Canadian  money,  but  it  requires  more  gold 
than  before  to  buy  it,  and  more  Irish  money  to  buy  the 
gold.  The  cost  to  the  people  of  Ireland  of  Canadian 
goods  tends  to  rise.  The  cost  to  Canadians  of  the 
products  of  Ireland  tends  to  fall.  Omitting,  altogether, 
consideration  of  money  prices,  we  may  say  that  the 
tax,  by  discouraging  Canadians  from  trading,  has  made 
necessary  a  new,  and,  for  Canada,  a  more  favorable 
rate  of  interchange  of  goods,  to  equalize  supply  and 
demand. 

i  Cf .  Part  I,  Ch.  VI,  §§  6,  7,  8,  9- 


48      ECONOMIC  ADVANTAGES  OF  COMMERCE 

The  illustrative  figures  which  have  been  given  show 
a  loss  to  Ireland  greater  than  the  amount  of  Canada's 
tax.1  Ireland's  loss,  however,  might  be  the  equivalent 

1  Professor  Edgeworth  seems  to  take  the  view  (Economic  Journal,  Vol.  VII, 
p.  397)  that  this  extreme  possibility  is  a  consequence  of  the  tax  being  collected, 
in  practice,  in  money,  and  that  if  it  were  collected  in  kind,  Ireland  (in  our  ex- 
ample) could  not  be  made  to  pay  more  than  the  tax.  His  thought  apparently 
is  that,  however  elastic  Canada's  demand  for  linen,  if  Ireland  paid  the  tax  tn 
linen,  in  addition  to  giving  Canadian  consumers  as  much  linen  as  before  for  the 
same  amount  of  wheat  as  before,  the  trade  would  again  be  in  equilibrium ;  that 
the  Canadian  consumers,  as  distinguished  from  the  government,  would  then  be 
entirely  unaffected  by  the  tax,  and  would  be  as  willing  to  buy  linen  with  wheat 
as  previously  and  in  as  large  quantities ;  and  that  Ireland,  therefore,  would  not 
have  to  pay  more  than  the  tax  to  get  the  accustomed  supply  of  wheat  from 
Canada. 

A  correct  distinction  between  the  circumstances  under  which  more  than  the 
burden  of  the  tax  might  conceivably  be  shifted  upon  Ireland  and  the  circum- 
stances under  which  the  full  amount  of  the  tax  would  be  the  limit  of  this  burden, 
is  based  on  what  the  Canadian  government  does  with  the  tax  and  not  at  all  on 
whether  it  is  initially  collected  in  money  or  in  kind.  We  may  rightly  conclude 
that  a  Canadian  import  tax  collected  in  linen  could  not  impose  a  greater  burden 
upon  Ireland  than  the  amount  of  the  tax,  if  we  suppose  the  Canadian  govern- 
ment to  throw  the  linen  it  receives  as  taxes  into  the  sea  or  if  we  assume  that  it 
uses  the  linen  so  received  for  a  purpose  which  would  otherwise  not  be  carried 
out.  We  may  reach  exactly  the  same  conclusion  with  equal  certainty,  however, 
if  we  suppose  the  tax  to  be  initially  collected  in  money  and  the  money  then  used 
to  buy  the  linen  to  be  disposed  of  in  one  of  these  two  ways.  If  the  burden  of  this 
tax  collected  in  money  falls  entirely  upon  Ireland,  then  Ireland  must  sell  enough 
more  linen  (assuming  she  has  no  other  exports)  to  pay  it.  But  the  Canadian 
government  expends  the  entire  money  returns  from  the  tax  for  linen  which, 
otherwise,  by  our  present  hypothesis,  the  government  would  not  buy.  In 
other  words,  Canada  buys  as  much  more  linen  as  Ireland  must  sell  additional 
to  pay  the  tax.  If  Ireland,  therefore,  thus  bears  the  entire  burden  of  the 
tax  by  exporting  extra  linen,  the  remainder  of  her  linen  will  find  the  same 
market  as  previously  and  will  bring  her  as  much  wheat  as  before. 

But  if  the  Canadian  government  would  use  about  the  same  amount  of  linen 
anyway,  then  for  the  government  to  get  this  linen  by  taxing  linen  imports  in 
kind  (and  likewise  by  taxing  them  in  money)  instead  of  by  purchasing  the  de- 
sired linen  with  the  proceeds  of  internal  taxes,  means  that,  whereas  the  govern- 
ment before,  in  effect,  offered  say  wheat  (if  the  money  equivalent  is  offered,  our 
conclusion  would  be  the  same)  taken  in  taxes  for  the  desired  linen,  now  it  offers 
nothing.  Both  individual  Canadian  consumers  and  the  Canadian  government 
had  been  offering  wheat  for  linen.  Now  only  the  former  are  doing  so.  The 
people  of  Ireland,  if  the  Canadian  wheat  is  necessary  for  them,  must  now  buy 
as  much  wheat  with  linen  (assuming  them  to  have  nothing  else  exportable)  from 


THE  INCIDENCE  OF  TARIFFS  FOR  REVENUE    49 

of  the  tax,  or  it  might  be  considerably  less  than  the  tax. 
Thus,  the  equilibrium  of  trade  might  be  restored  when 
Canadian  wheat  had  gone  up  to  $1.03  a  bushel,  and 
Irish  linen  down  to  $0.96  a  yard,  making  $1.06  with  the 
tax.  Then  Canadians  would  be  paying  6  cents  of  the 
10  cents  tax  on  each  yard,  but  getting  back  3  cents 
of  it  in  the  higher  price  of  wheat.  Ireland  would  be 
paying  the  larger  part  of  the  tax,  but  Canada  would 
have  failed  to  shift  all  of  it  upon  Ireland. 

Two  conditions,  then,  or  sets  of  conditions,  favor  the 
tax-levying  country  in  any  attempt  to  shift  the  burden 
of  the  tax  upon  the  country  trading  with  it.  In  the 
first  place,  the  tax-levying  country  is  advantaged  by 

the  Canadian  people  individually  as  they  previously  bought  from  individual 
Canadians  and  the  Canadian  government  together.  If  the  Canadian  people, 
as  individuals,  have  a  comparatively  elastic  demand  for  linen,  Ireland  must  offer 
them  for  their  individual  consumption,  besides  what  their  government  gets, 
about  as  much  linen  as  before  per  bushel  of  wheat  or  they  will  not  trade  to  any- 
thing like  the  former  extent.  Ireland  must  therefore  pay  most  or  all  of  the  tax. 
But  Ireland  will  then  only  be  getting  the  wheat  she  previously  got  from  Cana- 
dians as  individuals  and  will  not  be  getting  what  she  previously  got  as  a  result 
of  her  trade  with  the  Canadian  government.  This  additional  amount  she  must 
now  get  (for  we  are  supposing  her  demand  to  be  inelastic)  from  Canadians  as 
individuals,  and  to  do  so  she  must  sell  more  linen.  The  result  may  be,  even 
though  Canada's  demand  for  linen  is  somewhat  elastic,  that  the  marginal  utility 
of  linen  to  Canadian  consumers  falls,  and  that  Ireland  must  offer  more  than 
before,  per  bushel  of  wheat,  besides  paying  the  tax. 

It  is  true  that  if  Canadians  are  released  from  a  tax  they  themselves  previously 
paid,  they  may  want  more  linen  than  before,  but  the  probability  is  that  their 
greater  prosperity  so  resulting  would  be  enjoyed  in  other  ways  also  and  would 
but  slightly  affect  their  demand  for  linen.  And  unless  the  entire  gain  from 
remission  of  the  taxes  formerly  spent  by  the  government  for  linen  were  now 
spent  by  the  Canadian  people  for  additional  linen  beyond  their  previous  indi- 
vidual consumption,  the  new  demand  resulting  from  their  greater  prosperity 
would  not  take  the  place  of  the  former  demand  by  their  government. 

We  cannot  safely  conclude,  therefore,  that  if  the  tax  is  collected  in  kind, 
Ireland  cannot  possibly  lose  more  than  its  equivalent.  As  is  shown  in  the  text, 
any  great  shifting  of  taxes  to  foreign  nations  is  rather  a  theoretical  possibility 
than  a  practical  probability,  but  if  it  is  a  theoretical  possibility  when  collected 
in  money,  it  is  also  a  theoretical  possibility,  and  to  the  same  extent,  when  col- 
lected in  kind. 


PART  H  —  E 


50     ECONOMIC  ADVANTAGES  OF  COMMERCE 

having  a  very  elastic  demand  for  the  goods  of  the  other, 
coupled  with  monopoly  of  consumption  of  the  goods 
of  the  other.1  In  the  second  place,  the  tax-levying  coun- 
try is  aided  if  it  has  a  monopoly  of  production  of  the 
goods  it  sells  while  the  other  country  has  an  inelastic 
demand  for  those  goods.2 

In  practice,  the  conditions  under  which  a  country  can 
shift  all  or  most  of  its  import  taxes  upon  another,  are 
unlikely  to  occur,  or,  at  least,  are  unlikely  to  occur  in 
conjunction.  To  begin  with,  we  cannot  expect  that, 
in  general,  the  country  exporting  the  taxed  product  will 
have  an  inelastic  demand  for  the  product  or  products 
of  the  taxing  country.  And,  secondly,  a  very  slight 
change  in  relative  prices  may  bring  additional  articles 
within  the  demand  of  the  taxing  country,  thus  main- 
taining the  equilibrium  of  trade  nearly  where  it  was 
before.  To  illustrate,  a  slight  rise  of  Canadian  prices 
and  a  slight  fall  of  Irish  prices  may  induce  Canadians 
to  buy  potatoes,  silks,  and  laces,  as  well  as  linen,  in  Ire- 
land. Then  equilibrium  may  result  without  a  sufficient 
change  in  the  rate  of  trade  to  throw  upon  Ireland  much 
of  the  burden  of  the  import  tax. 

Thirdly,  and  probably  most  important  of  all,  the 
taxing  country  cannot  ordinarily  shift  much  of  the  bur- 
den of  its  import  duties  to  another,  because  third  coun- 
tries offer  to  this  other  a  competing  or  alternative  trade. 
Thus,  Canada  probably  cannot  throw  upon  Ireland 
the  burden  of  a  tax  on  Canada's  imports,  because  Ire- 
land has  the  alternative  of  trading  with  India,  Argentina, 
the  United  States,  and  other  countries.  If  Canada 
buys  less  Irish  linen  because  of  the  tax,  so  that  money 

1  Bastable,  The  Theory  of  International  Trade,  fourth  edition,  London  (Mac- 
allan), 1903,  p.  116.  *Ibid.,  pp.  116,  117. 


THE  INCIDENCE  OF  TARIFFS  FOR  REVENUE    51 

flows  into  Canada  and  Canadian  prices  rise,  Ireland 
will  buy  wheat  of  India,  the  United  States,  Argentina, 
or  Russia,  rather  than  pay  higher  prices  for  Canadian 
wheat.  In  short,  the  Canadian  wheat  producers  must 
take  the  same  prices  charged  elsewhere,  or  export  no 
wheat.1  Likewise,  rather  than  sell  their  linen  to  Canada 
for  a  much  lower  price  than  before,  the  people  of  Ireland 
would  export  more  to  other  markets.  Most,  if  not  all, 
of  the  tax  would  be  pretty  likely  to  fall  upon  the  people 
of  the  taxing  country;  and  even  if  this  were  not  true, 
the  attempt  to  tax  other  nations  is  a  game  at  which  all 
can  play. 

The  fact  that  other  countries  than  Ireland  and  Canada 
are  to  be  reckoned  with,  means,  also,  that  the  general 
price  level  in  Ireland  would  probably  fall  very  little  as 
a  consequence  of  Canada's  tax.  Though  an  inflow  of 
money  into  Canada  due  to  her  decreased  imports  might 
somewhat  raise  the  level  of  Canada's  prices,  any  corre- 
sponding fall  in  Irish  prices  would  make  Ireland  a  good 
place  to  buy  in  and  would  cause  money  to  flow  from 
third  and  fourth  countries  into  Ireland,  even  if  Cana- 
dians were  prevented  by  their  import  tax  from  buying 
in  Ireland.  The  fall  of  prices  would,  then,  if  it  took 
place,  be  distributed  over  several  countries  and  would 
not  probably  be  confined  to  Ireland.  It  would  be  very 
slight,  therefore,  in  any  country.  The  chief  effect  of 
the  redistribution  of  gold  consequent  on  Canada's  tax 
would  be  seen  in  a  rise  of  Canadian  prices  and  not  in  a 
fall  of  Irish  prices. 

1  The  exact  effect,  in  the  absence  of  any  disturbing  factors,  would  be  a  trans- 
ference, in  part,  of  the  Irish  demand  for  wheat  to  these  other  countries;  a  very 
slight  increase,  generally,  of  the  price  of  wheat,  and,  therefore,  a  very  slight 
increase  of  the  price  of  the  Canadian  wheat  still  exported;  and  a  very  slight 
decrease  in  the  price  received  by  Ireland  for  linen. 


52     ECONOMIC  ADVANTAGES  OF  COMMERCE 

§4 
The  Ultimate  Incidence  of  a  Revenue  Duty  on  Exports 

Duties  for  revenue  may  be  levied  on  exports,  if  so 
desired,  as  well  as  on  imports,  though  the  present  prac- 
tice is  to  levy  them  on  imports.  Here,  again,  there  are 
various  possibilities  as  to  shifting.  Suppose  that  Canada 
levies  a  duty  of  ten  cents  a  bushel  on  the  export  of  wheat: 
The  production  of  wheat,  in  Canada,  for  export,  would 
be  decreased,  unless  the  tax  could  be  shifted  upon  foreign 
consumers.  If  the  tax  could  not  be  shifted,  those  wheat 
producers  who  were  making  but  the  usual  return  to 
industry  (the  marginal  producers)  would  change  to 
another  line  of  production.  If  the  wheat  consumers 
of  Ireland  (and  of  other  countries  getting  their  wheat 
from  Canada)  should  have  an  absolutely  inelastic  demand 
for  wheat  and  could  get  wheat  nowhere  else,  they  would 
pay  the  higher  price  for  wheat  rather  than  not  get  the 
usual  amount  of  it,  and  thereby  would  be  paying  the 
tax.  In  fact,  if  their  demand  were  altogether  inelastic, 
they  would  soon  be  paying  more  than  the  tax.1  For 
the  whole  amount  paid  by  purchasers  of  Canadian  wheat, 
including  the  part  collected  by  the  Canadian  govern- 
ment as  export  tax,  goes  to  Canada.  This  means  that 
if  the  wheat  consumers  of  Ireland  (and  elsewhere)  paid 
the  tax  in  addition  to  what  they  were  previously  paying, 
there  would  be  a  flow  of  gold  into  Canada.  Canadian 
prices  would  rise.  Prices  in  Ireland  would  fall.  Con- 
sumers in  Ireland  would  then  be  paying  more  for  wheat 
by  the  amount  of  the  tax  plus  the  amount  of  rise  (due 
to  gold  flow)  of  net  price ;  while  the  fall  of  Irish  prices 
would  mean  cheaper  linen  for  Canada.  A  bushel  of 

1  Mill,  Principles  of  Political  Economy,  Book  V,  Ch.  IV,  §  6. 


THE  INCIDENCE  OF  TARIFFS  FOR  REVENUE    53 

wheat,  even  after  subtraction  of  the  tax,  would  buy 
more  linen  than  before. 

.  But  if  Ireland's  demand  for  wheat  is  decidedly  elastic, 
or  can  be  easily  satisfied  from  other  sources  of  supply, 
then  the  increased  price  resulting  from  the  export  tax 
will  cause  an  immediate  falling  off  of  Irish  purchases. 
Let  us  suppose  this  falling  off  of  Irish  demand  to  be 
sufficient  so  that,  even  with  the  addition  to  the  price, 
of  the  tax,  the  money  obligations  from  Ireland  to  Canada 
are  less  than  before.  Then  a  balance  of  gold  will  flow 
from  Canada  to  Ireland.  Canadian  prices  will  fall 
and  prices  in  Ireland  rise.  If  Canadian  demand  for 
linen  is  comparatively  inelastic,  this  flow  and  change  of 
prices  may  go  to  a  considerable  extent  before  Canadian 
demand  for  linen  decreases  and  Irish  demand  for  wheat 
(and  other  Canadian  products)  increases  enough  to 
bring  equilibrium.  At  any  rate,  the  fall  of  Canadian 
and  rise  of  Irish  prices  will  mean  that  at  least  a  part  of 
Canada's  export  tax  has  been  shifted  back  upon  Canada. 
It  is  conceivable  that  Canadian  wheat  will  fall  so  far 
in  price  that,  even  with  the  tax,  Ireland  gets  it  as  cheaply 
as  or  more  cheaply  than  before,  while  Canada  pays  more 
for  Irish  linen.  In  that  case,  Canada,  so  far  from  taxing 
another  country  or  other  countries,  would  herself  lose 
more  than  the  tax.  If  we  assume  Canada  and  Ireland 
to  have  different  standards  of  value,  our  conclusions 
will  be  the  same.1 

It  should  be  clearly  understood  that  the  loss  to  Canada 
(assuming  the  result  just  discussed)  does  not  fall,  if  the 
taxed  article  is  produced  at  nearly  constant  cost,  on  the 
producers  of  that  article  alone.  For  these  producers 
would  refuse  to  accept  lower  returns  and  remain  in  the 

1  Cf.  §  3  of  this  chapter  (III  of  Part  II). 


54     ECONOMIC  ADVANTAGES  OF  COMMERCE 

same  business  when  other  lines  were  more  profitable. 
They  accept  the  lower  prices  when  and  because  the 
outflow  of  money  makes  Canadian  prices,  generally, 
lower. 

But  the  goods  taxed  may  be  produced  under  condi- 
tions of  sharply  increasing  cost  (i.e.  by  some  producers 
less  advantageously  than  by  others).  This  may  be  the 
case  with  wheat,  chosen  as  our  illustration  of  the  taxed 
article.  On  this  assumption,  much  of  the  loss  due  to 
the  tax  may  fall  on  the  owners  of  wheat  lands.  Those 
producing  at  the  margin  of  cultivation  (those  just  mak- 
ing enough  to  keep  them  in  the  industry)  will  refuse  to 
bear  this  loss,  and  will  cease  producing.  Those  producing 
under  more  favorable  circumstances  (on  more  fertile 
or  better  situated  land)  may  prefer  to  suffer  consider- 
able loss  out  of  what  would  have  been  their  surplus  or 
rent,1  rather  than  to  cease  wheat  raising.2  After  the 
tax  has  diminished  foreign  demand  for  Canadian  wheat, 
the  more  advantageously  situated  Canadian  wheat 
producers  can  fill  this  smaller  demand  at  lower  net 
prices  than  before,  and  still  realize,  because  of  their 
advantages  of  soil  and  situation,  a  reasonable  profit.  A 
price  sufficient  to  keep  the  poorer  situated  producers 
in  business,  plus  the  tax,  will  not  be  paid  by  enough 
foreign  consumers  to  take  the  previous  annual  supply 
of  Canadian  wheat.  The  price  will  fall.  Canadian 
owners  of  wheat  lands  will  derive  a  smaller  return  from 
those  lands.  If  there  is  a  surplus  flow  of  gold  from 
Canada,  because  of  excess  purchases  of  Irish  linen  over 
sales  of  Canadian  wheat,  the  price  of  the  wheat  will 
fall  still  further,  along  with  prices  of  other  Canadian 

1  Cf.  Bastable,  The  Theory  of  International  Trade,  p.  114. 
8  Cf.  Ch.  II  (of  Part  II),  §  4. 


THE  INCIDENCE  OF  TARIFFS  FOR  REVENUE     55 

goods.     But  it  will  still  be  true  that  a  special  loss  has 
fallen  upon  the  owners  of  wheat  lands.1 

As  in  the  case  of  the  import,  so  in  the  case  of  the  export 
revenue  tax,  we  must  emphasize  the  unlikelihood  that 
a  country  will  be  able  to  shift  the  principal  part  of  its 
tax  burden  upon  other  countries.  So  soon  as  trade 
with  Canada  becomes,  because  of  the  tax,  appreciably 
less  profitable  to  Ireland,  the  latter  country  is  likely 
to  trade  more  with  other  nations  and  communities,  and 
less  with  Canada.  For  this  reason  particularly,  as  well 
as  the  fact  that  the  other  country,  Ireland,  is  quite  as 
likely  as  the  tax-levying  country,  to  have  an  elastic 
demand  for  the  goods  it  imports,  there  is  a  reasonable 
probability  that  the  people  of  each  country  will  them- 
selves have  to  pay,  in  the  main,  the  cost  of  running  their 
own  government  and  carrying  on  its  functions. 

§5 
Summary 

Revenue  tariffs  we  have  classified  as  import  and  export 
tariffs.  A  revenue  tariff,  as  such,  is  expected  to  secure 
revenue  for  government  with  the  least  possible  effect 
on  industry.  A  protective  tariff  is  specifically  intended 
to  turn  industry  into  channels  it  would  otherwise  not 
enter. 

Revenue  tariffs  on  imported  goods  may  fall  on  the 
consumers  in  the  tax-levying  country,  or  may,  under 
certain  hypothetical  circumstances,  fall  upon  the  country 
(or  countries)  exporting  the  taxed  goods.  If  the  demand 
for  the  goods  in  the  taxing  country  is  elastic;  if  the 

1  In  a  similar  way  it  might  be  shown  that,  even  if  Canada  succeeds  in  throw- 
ing the  main  burden  of  the  tax  upon  Ireland,  owners  of  Canadian  wheat  lands 
might,  as  a  separate  class,  have  their  prosperity  decreased. 


56     ECONOMIC  ADVANTAGES  OF  COMMERCE 

demand  for  the  goods  produced  in  it  is  in  other  coun- 
tries comparatively  inelastic ;  and  if  these  other  coun- 
tries have  no  other  place  to  sell  their  exports  and  buy 
the  goods  they  desire;  then  the  tax  burden  may  be 
shifted  in  part,  or  in  whole,  or  more,  upon  them.  But 
in  the  actual  commercial  world,  circumstances  are  not 
likely  thus  to  favor  the  tax-levying  country. 

In  the  case  of  tariffs  on  exported  goods,  the  hypotheti- 
cally  possible  consequences  are  not  dissimilar.  A  suffi- 
ciently inelastic  demand  from  other  countries,  for  the 
taxed  goods,  will  throw  upon  them  a  burden  perhaps 
equal  to  or  in  excess  of  the  tax,  to  the  advantage  of  the 
taxing  country.  On  the  other  hand,  the  country  taxing 
its  exports  may,  if  the  foreign  demand  for  the  taxed 
goods  is  elastic  while  its  demand  for  foreign  goods  is 
inelastic,  not  only  pay,  itself,  the  entire  tax,  but  may  also 
carry  on  its  trade  with  foreign  countries  at  a  less  favor- 
able rate  of  interchange  to  it,  than  before.  The  general 
rule  probably  is  that  a  government  is  mainly  supported 
by  those  subject  to  it.  If  it  were  possible  to  support 
government  by  shifting  taxes  upon  foreign  countries, 
all  nations  would  be  likely  to  attempt  it,  with  consequent 
cancellation  or  partial  cancellation  of  effects. 


CHAPTER  IV 

THE  .EFFECT  OF  A  PROTECTIVE  TARIFF  ON  NATIONAL 
WEALTH 


The  Effect  of  a  Protective  Tariff  on  a  Country's  Export 

Trade 

IN  discussing  the  protective  tariff,  a  natural  starting 
point  is  the  question  of  its  effect  on  the  supply  of  goods 
brought  from  foreign  countries.  A  purely  revenue  tariff 
is  intended  to  have  the  least  possible  effect  on  the  flow 
of  trade.  A  protective  tariff  prevents  goods  from  coming 
into  the  "protected"  country,  is,  in  fact,  particularly 
intended  so  to  do,  by,  in  effect,  fining  the  importers. 
Thus,  a  Canadian  tariff  on  linen  of  50  cents  a  yard 
may  be  said  to  fine  the  importers  of  linen  to  that  extent. 
This  discourages  importation  and  so  tends  to  decrease, 
in  Canada,  the  supply  of  linen.  In  consequence  of  the 
decreased  supply  of  linen  in  Canada,  the  price  advances. 
Either  it  must  advance  by  about  the  equivalent  of  the 
tax,1  or  the  linen  will  not  be  imported.  This  high  price, 
however,  causes  a  falling  off  in  the  demand  for  linen 
brought  from  abroad,  and  a  shifting  of  this  demand 
to  the  home  product.  If  linen  from  Ireland  was  $1.00 
and  cannot  now  be  sold  for  less  than  $1.50,  and  if  Cana- 
dians can  manufacture  it  profitably  for  $1.43,  the  sales 

1  See,  however,  discussion  in  this  chapter  (IV  of  Part  II),  §§   6  and  7.    Cf. 
Ch.  Ill  (of  Part  II),  §  3- 

57 


58     ECONOMIC  ADVANTAGES  OF  COMMERCE 

of  Canadian  linen  in  Canada  will  increase.  Canadian 
production  is  thus  encouraged,  by  government  aid,  to 
follow  a  line  which  it  otherwise  would  not. 

This  purposeful  interfering  with  importation  disturbs 
the  previously  existing  equilibrium  of  trade  conditions. 
Canada,  for  a  time,  continues  to  export  wheat  or  other 
goods,  though  refusing  to  import  much  linen.  Gold, 
therefore,  flows  out  of  Ireland  and  into  Canada.  This 
raises  Canadian  prices  and  lowers  prices  in  Ireland.1 
The  prices,  therefore,  of  goods  which  Canada  has  ex- 
ported, e.g.  wheat,  may  rise  so  high  that  the  Irish  and 
other  foreign  demand,  if  it  does  not  cease,  will  at  least 
grow  smaller.  Or,  if  some  of  these  goods,  such  as  wheat, 
cannot  be  sold  abroad  even  in  smaller  quantities  for  a 
higher  price  than  before,  because  of  competition  from 
other  sources  of  supply,  then  the  higher  money  cost  of 
production  in  Canada  will  cause  production  for  a  foreign 
market  to  decrease.  In  the  long  run,  by  so  much  as  a 
protective  tariff  directly  limits  imports,  by  just  so  much 
will  it  indirectly  injure  the  levying  country's  export 
trade.2  This  is  true  whether  the  different  trading  coun- 

1  Or,  if  there  is  a  general  tendency  for  prices  to  fall,  as  from  a  more  rapid 
increase  of  trade  than  of  money,  Canadian  prices  fall  less  than  do  Irish  prices ; 
while,  if  there  is  a  general  tendency  for  prices  to  rise,  Canadian  prices  rise  more 
than  Irish  prices.    The  essential  fact  is,  that  Canadian  prices  rise  by  comparison 
with  Irish  prices,  while  Irish  prices  fall  by  comparison  with  Canadian  prices.     It 
would  complicate  and  make  harder  to  follow  our  arguments  to  add  this  expla- 
nation in  each  chapter  throughout  Parts  I  and  II,  but  the  reader  may,  with 
advantage,  bear  it  in  mind. 

2  Whatever  goods  continue  to  be  exported  until  Canadian  prices  have  appre- 
ciably risen,  would  more  probably  be  goods  produced  under  conditions  of  in- 
creasing cost  and  goods  in  which  competition  from  other  sources  of  supply  would 
not  prevent  Canadian  sales  even  at  somewhat  higher  prices  than  before.     If 
all  goods  were  produced  under  conditions  of  absolutely  constant  cost  and  could 
be  secured  equally  well  from  other  sources,  if  society  were  in  a  state  of  economic 
equilibrium,  and  if  there  were  no  economic  friction,  then  Canadian  prices  could 
change  only  infinitesimally  as  a  result  of  money  inflow  caused  by  the  tariff.    For 


PROTECTION  AND  NATIONAL  WEALTH       59 

tries  have  a  common  standard  of  value,  or  unrelated 
monetary  systems,  or  no  monetary  systems.  The 
Irish  manufacturers  of  linen  will  be  forced  by  the  more 
direct  action  of  the  tariff  to  seek  markets  elsewhere 
than  in  Canada.  The  Irish  consumers  of  wheat  will 
soon  make  use  of  the  alternative,  in  case  an  inflow  of 
gold  into  Canada  raises  wheat  prices  there  (or,  if  the 
currencies  are  unrelated,  in  case  more  Irish  money  than 
before  is  required  to  buy  a  given  amount  of  Canadian 
money),  of  buying  their  wheat  elsewhere.  The  result,  to 
Canada,  is  the  loss  of  what  had  been  a  profitable  trade. 
The  establishment  of  a  few  protected  industries  may 
serve  to  discourage  or  cripple  many  unprotected  indus- 
tries, for  it  means  higher  money  prices  and  a  consequent 
disadvantage  to  all  lines  of  export  trade.  Among  other 
things,  the  services  of  a  country's  mercantile  marine 
may  be  regarded  as  exports  of  that  country,  in  so  far  as 
these  services  are  rendered  to  and  are  paid  for  by,  the 
people  of  other  countries.  This,  like  other  parts  of  a 
country's  export  trade,  is  affected  unfavorably  if  the 
country  follows  the  protective  tariff  policy.  Besides 
the  injurious  effect  resulting  from  the  general  rise  of 
money  prices  in  the  protected  country,  on  the  exporta- 
tion of  any  of  that  country's  products,  there  is  the  special 
discouragement  which  results  if  the  production  of  these 
exportable  goods  requires  the  use  of  machinery  or  raw 
material  directly  raised  in  price  by  a  tariff  upon  it. 

the  least  tendency  to  rise  of  costs  would  at  once  turn  all  producers  away  from 
lines  of  production  for  a  foreign  market  in  which  prices  could  not  be  made  to 
rise  equally  fast,  and  prices  in  foreign  markets,  of  the  goods  in  question,  would 
not  rise  if  the  goods  could  be  secured  in  larger  quantity  from  other  sources,  at 
no  greater  cost  than  before.  A  protective  tariff  which  prevented  imports  would 
immediately  stop  exports.  Under  existing  conditions,  exports  would  be  corre- 
spondingly decreased  by  an  import  tariff  only  after  an  appreciable  lapse  of 
time. 


60     ECONOMIC  ADVANTAGES  OF  COMMERCE 

A  high  export  tariff,  intended  to  prevent  exports, 
would  eventually,  like  a  protective  import  duty,  decrease 
both  exports  and  imports,  but  the  export  duty  would 
decrease  exports  first.  The  diminution  of  exports  would 
mean  a  temporary  net  outflow  of  specie  from  the  duty- 
levying  country.  Finally,  prices  in  that  country  would 
be  so  low  that  its  people  would  more  largely  supply 
themselves  with  desired  goods  and  would  buy  less  goods 
abroad.1  It  is  not  essential,  however,  that  we  should 
consider  at  length  the  effects  of  high  export  duties,  be- 
cause, while  there  have  been  examples  of  such,  they  have 
been  much  less  common  than  high  import  duties,  and 
are,  at  present,  almost  unknown. 


How  a  Protective  Tariff  Sets  Up  Unprofitable  Industries 
at  the  General  Expense 

The  fairly  direct  and  practically  immediate  effect  of  a 
protective  tariff  is  to  raise  the  prices  of  protected  goods 
by  not  more  than  the  amount  of  the  tariff.  As  we  have 
seen,  if  Canada  levies  a  50  cents  tax  per  yard  on  linen, 
to  protect  Canadian  linen  production,  an  almost  imme- 
diate result  is  that  Canadian  linen  manufacturers  can 
charge  more  for  linen  than  otherwise  they  would  be  able 
to.  For  the  50  cents  tax  has,  as  a  first  consequence,2 
that  linen  from  Ireland  must  sell  for  $1.50  instead  of  $i 
a  yard.  The  tax,  therefore,  makes  it  possible  for  Cana- 
dian linen  producers  to  charge  prices  (except  as  hindered 

1  With  a  combination  of  high  protection  on  all  importable  goods,  and  high 
restrictive  export  taxes,  the  prices  of  protected  goods  would  rise  because  of  their 
greater  scarcity,  but  there  would  be  no  rise  of  other  prices  due  to  inflow  of  gold 
nor  any  fall  of  prices  due  to  its  outflow. 

2  See,  however,  §§  6  and  7  of  this  chapter  (IV  of  Part  II). 


PROTECTION  AND  NATIONAL  WEALTH      61 

by  competition  with  each  other)  higher  in  about  the 
same  proportion.  Without  the  tariff  protection,  Cana- 
dian linen  producers  must  sell  for  $i  a  yard  or  less,  if 
they  would  have  the  home  market.  If  all  of  them  were 
willing  to  do  this,  if  employing  manufacturers  and  their 
employees  were  willing  to  manufacture  linen  for  an 
average  return  of  $14  a  week,  or  less,  they  could  carry 
on  a  large  business  and  perhaps  almost  monopolize 
the  home  market,  even  without  a  tariff.  But  the  tariff, 
by  compelling  a  rise  in  the  imported  linen  to  $1.50,  en- 
ables the  now  protected  Canadians  to  charge  (say) 
$1.43,  and  still  be  sure  of  most  of  the  Canadian  market. 
Under  Schedule  K  of  the  late  Payne- Aldrich  tariff  law,  it 
was  found  by  the  Tariff  Board  that  an  average  duty  of 
184  per  cent  levied  by  the  United  States  on  16  varieties 
of  woolen  fabrics,  resulted  in  an  average  price  for  the 
home-produced  goods  67  per  cent  higher  than  the  price 
of  like  goods  abroad.1  The  tariff  has  in  this  regard  about 
the  same  effect  as  natural  barriers  and  resulting  high 
cost  of  transportation.  Either  natural  barriers  or  the 
artificial  barriers  of  a  protective  tariff  act  tend  to  make 
more  difficult  to  get  and  more  expensive  in  one  country, 
the  products  of  another,  and,  therefore,  to  enable  the 
home  producer  to  charge  higher  prices.  The  late  Pro- 
fessor William  Graham  Sumner  of  Yale  college  called 
attention  to  the  fact  that,  after  the  St.  Gothard  tunnel 
was  opened,  the  people  of  southern  Germany  petitioned 
for  higher  taxes  on  Italian  products  so  as  to  offset  the 
greater  cheapness  made  possible  by  the  tunnel.2 
The  protective  tariff  on  linen  makes  Canadian  manu- 

1  Report  of  the  Tariff  Board  on  Schedule  K  of  the  Tariff  Law,  1912,  Vol.  I. 
Part  I,  p.  14. 

2  Protectionism,  New  York  (Holt),  1885,  pp.  75,  ?6. 


62     ECONOMIC  ADVANTAGES  OF  COMMERCE 

facture  of  the  linen  much  more  profitable  than  it  would 
else  be,  since  it  enables  the  Canadian  manufacturers  to 
charge  much  higher  prices.  It  therefore  diverts  a  cer- 
tain amount  of  Canadian  labor  and  capital,  from  the 
production  of  wheat  and  from  other  lines,  into  the  pro- 
duction of  linen.  As  has  already  been  suggested,  if 
Canadians  want  to  go  into  the  linen  making  industry 
and  take  what  the  industry  will  yield  them  in  open  com- 
petition, they  can  do  so  without  the  tariff.  But  though 
they  can,  it  is  obvious  that  they  will  not.  For,  by  our 
familiar  assumption,  a  week's  labor  in  Canada  will 
produce  20  bushels  of  wheat,  and  will  therefore  earn,  if 
wheat  sells  for  $i  a  bushel,  $20.  A  week's  labor  will 
produce,  however,  but  14  yards  of  linen.  If  linen  is 
but  $i  a  yard  or  less,  the  week's  earnings  are  but  $14. 
Without  the  tariff,  therefore,  Canadians  can  go  into 
linen  production  if  they  want  to,  and  they  may  be  able 
to  make  a  fair  living  at  it;  but  they  will  not  want  to, 
for  the  reason  that  they  can  make  very  considerably 
more  in  another  line,  viz.  the  production  of  wheat. 
The  tariff,  by  enabling  them  to  get  $1.43  a  yard  or  more, 
though  at  the  expense  of  43  cents  a  yard  to  every  Cana- 
dian purchaser  of  linen,  makes  the  business  as  profitable 
as  the  other,  or  more  so,  and  induces  some  Canadians 
to  take  it  up.  A  protective  tariff,  therefore,  causes  the 
development  of  an  industry  in  a  location  or  country 
where  it  would  not  otherwise  exist,  by  making  possible 
higher  prices  and  correspondingly  higher  returns  to 
that  industry,  and  in  that  way  alone.  Under  free  trade 
conditions,  the  location  of  various  industries  within 
different  countries  is  determined,  as  we  have  seen,  by 
the  principle  of  relative  efficiency  in  production.  The 
greatest  profitable  degree  of  geographical  specialization 


PROTECTION  AND  NATIONAL  WEALTH       63 

results.  Under  protection,  this  specialization  is  pur- 
posely interfered  with,  and  what  industries  shall  be 
developed  and  maintained  in  the  protective  tariff  coun- 
try depends,  in  large  part,  on  governmental  favor. 

The  general  principle  of  free  trade  follows  directly 
from  what  we  have  learned  of  the  benefits  of  international 
trade.  Geographical  specialization,  so  far  as  it  develops 
naturally  under  free  trade  conditions,  yields  a  larger 
total  product  than  local  or  national  self-sufficiency ;  and 
of  this  larger  product  the  several  trading  nations  secure 
each  a  share.  Protection  prevents  this  specialization, 
makes  impossible  the  securing  of  the  larger  total  product, 
and,  therefore,  makes  the  protected  country  in  so  far 
poorer. 

To  illustrate,  consider  again  Canada's  50  cents  pro- 
tective duty  on  linen.  Before  the  laying  of  this  duty, 
the  average  Canadian  could  produce,  in  a  week,  20 
bushels  of  wheat,  worth  $20,  and  get,  by  sale  and  pur- 
chase, 20  yards  of  linen  in  return.1  With  two  weeks  of 
work,  he  could  secure  20  bushels  pjus  20  yards.  After 
the  protective  tax  is  laid,  he  is  practically  compelled  to 
buy  linen  in  Canada  at  $1.43  a  yard.  He  can  still 
produce  20  bushels  of  wheat  in  a  week  and  get  his  $20, 
but  for  the  $20  he  can  get  only  14  yards  of  linen.  Two 
weeks  of  work  will  net  him  20  bushels  plus  14  yards, 
which  is  6  yards  less  2  than  if  the  tariff  did  not  exist. 

Neither  can  it  be  said  that  the  Canadians  who  are 
tempted  into  linen  manufacturing  gain  any  more  than,  or 
as  much  as,  the  wheat  producers  lose.  For  we  have  seen 
that  those  who  care  to  manufacture  linen,  employers  and 
employees,  can  have  all  the  business  they  want  and  all 

1  Minus  cost  of  transportation,  etc. 

2  Ignoring  cost  of  transportation,  etc. 


64      ECONOMIC  ADVANTAGES  OF  COMMERCE 

the  employment  they  want,  without  the  tariff,  if  they 
will  sell  the  linen  at  a  low  enough  price,  say  $i  or  less  a 
yard,  and  take  what  the  business  will  earn,  as  wages  and 
profits,  viz.  about  $14  a  week  (or  perhaps,  if  they  wish 
to  keep  linen  from  Ireland  entirely  out  and  monopolize 
the  market,  somewhat  less).  If  the  tariff  enables  them 
to  get  $1.43  a  yard  instead  of  $i,  the  best  that  can  pos- 
sibly be  said  for  the  tariff  is  that  it  gives  the  linen  makers 
43  cents  for  every  43  cents  it  takes  away  from  the  wheat 
raisers  or  others  who  buy  the  linen.  If  there  is  any  way 
by  which  protection  can  give  43  cents  to  any  protected 
interest,  without  taking  at  least  43  cents  away  from  some 
person  or  persons  buying  the  taxed  article,  the  exact 
manner  in  which  protection  does  this  should  be  carefully 
set  forth  by  defenders  of  the  policy.  The  late  Professor 
Sumner  said:1  "If  Protection  is  anything  else  than 
mutual  tribute,  then  it  is  magic." 

But  protection  does  worse  than  take  from  one  person 
in  the  protectionist  country  exactly  what  it  gives  to 
another.  In  our  illustration,  protection  does  worse  than 
take  from  the  Canadian  wheat  producers  exactly  what 
it  gives  to  the  Canadian  linen  manufacturers.  It  takes 
more  from  the  wheat  raisers  than  it  gives  to  those  who 
become  linen  producers.  The  wheat  raisers  have  to  pay 
43  cents  extra  on  every  yard  bought,  in  order  that  the 
linen  makers  may  receive  $1.43  for  what  would  other- 
wise be  $i  worth  of  linen,  or  $20  a  week  in  an  occupa- 
tion that  would  otherwise  yield  only  $14.  But,  by 
hypothesis,  they  could  earn  $20  anyhow,  if  they  would 
remain  in  the  business  of  wheat  production.  Therefore, 
the  people  who  do  engage  in  wheat  production  have  to 
lose  $6  on  20  yards  of  linen  in  order  that  others  may 

1  Protectionism,  p.  160. 


PROTECTION  AND  NATIONAL  WEALTH      65 

secure  $20  a  week  at  linen  manufacturing,  when  these 
others  could  secure  $20  a  week  in  wheat  production 
without  taxing  any  one  else.  It  would  seem  certain, 
then,  that  the  taxed  class  loses  more  than  the  protected 
class  gains,  if  indeed  the  latter  class  gains  anything  at 
all.  What  the  situation  amounts  to,  in  our  illustration, 
is  that  the  people  in  one  industry  are  taxed  to  encourage 
and  keep  going  another  industry  which  pays  so  ill  that 
no  one  in  the  country  would  go  into  it  if  it  were  not 
favored  by  this  policy.  This  is  what  Professor  Sumner 
had  in  mind  when  he  said  that,  by  the  whole  logic  of  the 
protectionist  system,  the  industries  to  be  aided  are  "the 
industries  which  do  not  pay,"  l  and  that  the  process,  so 
called,  of  " creating  a  new  industry"  means  simply  the 
taking  of  one  industry  and  setting  it  "as  a  parasite  to 
live  upon  another."  2 

Various  facts  brought  out  by  the  investigations  of  the 
Tariff  Board  would  seem  to  show  that  the  establishment 
in  the  United  States  by  the  protective  tariff,  of  the  wool 
manufacturing  industry,  has  thus  been  the  establishment 
of  a  parasitic  industry  at  the  general  expense.  We  have 
already  seen  3  that  many  woolen  goods  have  been  greatly 
raised  in  price  because  of  the  exclusion,  by  protection, 
of  foreign  goods.  The  home  producers  must  receive 
these  higher  prices  in  order  that  they  may  receive,  as  a 
whole,  as  large  returns  as  they  might  otherwise  have 
secured  in  unprotected  lines ;  in  particular,  they  must 
charge  these  prices  in  order  that  the  wages  paid  to  em- 
ployees may  be  high  enough  to  keep  the  latter  in  the 
wool  manufacturing  business,  and,  therefore,  that  the 
wages  may  be  as  high  as  can  be  got  in  other  employments. 

1  Protectionism,  p.  48.  2  Ibid.,  p.  45- 

«  §  2  of  this  chapter  (IV  of  Part  II). 
PART  H  —  V 


66      ECONOMIC  ADVANTAGES  OF  COMMERCE 

Since  wages  in  general  in  the  United  States  are  high  and 
since  American  woolen  manufacturing  concerns  seem 
to  have  no  special  advantages  either  in  equipment  or  in 
efficiency  of  labor  over  their  foreign  rivals,1  it  follows 
that  the  cost  per  yard  of  woolen  cloth  made  in  this  coun- 
try is  high.  According  to  the  estimates  of  the  Tariff 
Board,2  the  cost  of  turning  wool  into  tops  is  about  80  per 
cent  more  here  than  in  England,  of  producing  yarn  from 
the  tops  about  100  per  cent  more,  and  of  manufacturing 
the  yarn  into  cloth  from  66  to  170  per  cent  more,  accord- 
ing to  the  kind  of  fabric  in  question.  The  effect  of  pro- 
tecting the  woolen  manufacturing  industry  in  the  United 
States  has  been,  therefore,  that  the  consumers,  that  is, 
the  Americans  engaged  in  all  other  lines  of  industry, 
have  had  to  pay  much  higher  prices  for  woolen  goods 
than  would  otherwise  be  necessary,  merely  that  those 
engaged  in  the  woolen  industries  might  receive  as  high 
profits  and  wages  as  they  could  get  even  without  pro- 
tection in  other  lines  of  activity.  Were  it  not  for  pro- 
tection they  would  have  been  engaged  in  these  other 
lines  of  activity,  perhaps  largely  in  the  production  of 
articles  for  export,  in  transportation,  and  in  various 
commercial  pursuits.  Protection  has  drawn  them  out 
of  these  lines  at  a  very  considerable  loss  to  the  rest  of 
the  nation  and  with  no  appreciable  permanent  gain  to 
them,  if  indeed  they  have  not  eventually  shared  in  the 
general  loss.  It  would  appear  certain,  therefore,  that 
in  this  instance,  as  in  general,  protection  has  imposed  a 
cost  upon  those  in  unprotected  industries,  greater  than 
any  gain  which  it  can  be  asserted  to  have  brought  to 
those  in  the  lines  protected. 

» Report  of  the  Tariff  Board  on  Schedule  K  of  the  Tariff  Law,  Vol.  I,  Part 
I,  p.  16.  *Ibid.,  pp.  16,  17. 


PROTECTION  AND  NATIONAL  WEALTH      67 


The  Effect  of  Protection  on  the  Money  Prices  of  Pro- 
tected Goods  and  on  the  Money  Prices  of  Unprotected 
Goods 

For  a  brief  time  after  a  protective  tariff  is  levied  on 
imports,  the  protected  country,  e.g.  Canada,  will  export 
about  as  much  as  if  trade  were  free ; 1  but  such  a  flow  of 
exports  will  not  be  continuous.  When,  as  a  result  of 
the  tariff,  Canada  diminishes  its  importations,  there  will 
be,  as  has  been  sufficiently  explained,  a  net  inflow  of 
gold.  Canadian  prices  rise  as  compared  to  foreign 
prices,  and,  if  the  amount  of  trade  and  other  factors 
remain  the  same,  rise  in  exact  proportion  to  the  increase 
of  money.  If,  for  any  reason,  prices  do  not  at  once 
become  higher  than  before  relatively  to  prices  abroad, 
the  gold  inflow  will  continue  until  they  do.  And  when, 
because  of  the  increase  of  money,  prices  rise,  this  rise 
of  prices  will  affect  protected  and  unprotected  goods 
alike.  The  increase  of  money,  with  no  corresponding 
increase  of  other  wealth,  must  mean  rise  of  prices  of 
other  wealth,  else,  with  the  greater  amount  of  money, 
the  demand  for  this  wealth  would  exceed  the  supply. 
And  as  far  as  the  increase  of  money  by  itself  is  concerned, 
it  would  affect  all  prices  in  Canada  to  the  same  extent. 
The  primary  effect,  then,  of  the  assumed  tariff,  is  to 
raise  the  price  of  linen,  in  Canada,  from  $i  to  $1.43  a 
yard,  while  not  affecting  the  price  of  wheat.  The 
secondary  effect  results  from  the  inflow  of  money.2 

1  See  §  i  (and  footnotes)  of  this  chapter  (IV  of  Part  II). 

*  Cf .  The  Purchasing  Power  of  Money,  by  Irving  Fisher  assisted  by  Harry  G. 
Brown,  New  York  (Macmillan),  IQII,  p.  94.  In  justification  of  the  above  mode 
of  presentation,  it  may  be  said  that  the  drawing  of  labor  into  the  protected  in- 
dustry (linen  production),  cannot  permanently  raise  the  prices  of  unprotected 


68      ECONOMIC  ADVANTAGES  OF  COMMERCE 

Suppose  money  in  Canada  increases,  because  of  the 
tariff,  by  10  per  cent.  Then  the  price  of  Canadian  wheat, 
assuming  it  to  be  produced  at  approximately  constant 
cost  per  bushel 1  regardless  of  whether  somewhat  less  or 
somewhat  more  is  produced,  would  tend  to  rise  from  $i 
to  $1.10  a  bushel;2  and  the  price  of  linen  would  rise, 
in  addition  to  the  rise  directly  occasioned  by  the  tariff, 
from  $1.43  to  $1.57  a  yard,  i.e.  in  the  same  ratio  as  the 
price  of  wheat.  How  largely  the  prices  of  unprotected 
goods  produced  in  the  United  States  have  thus  been 
made  higher  by  this  indirect  action  of  the  tariff,  it  is 
impossible  to  say,  but  that  the  prices  of  many  such  goods 
have  been  so  raised  to  some  extent,  we  may  reasonably 
conclude. 

Here  we  are  brought  again,  by  a  somewhat  different 
route,  to  the  conclusion  that  a  protective  tariff  tends 
towards  national  poverty.  For,  while  the  increased 
quantity  of  money  tends  to  raise  all  money  incomes  in 
the  same  ratio  that  it  raises  the  prices  of  goods,  and  so 
tends  to  leave  people  in  the  same  relative  position ;  yet 
the  original  and  special  rise  in  the  prices  of  the  protected 

goods,  e.g.  wheat,  by  decreasing  the  supply  of  these  goods,  unless  there  is  this 
inflow  of  specie.  For  no  one,  by  our  hypothesis,  will  leave  the  production  of 
wheat  at  $i  a  bushel  unless  he  can  get  $1.43  a  yard  for  linen,  and  no  one  would 
leave  the  production  of  wheat  at  any  higher  price  than  $i  unless  he  could  secure 
more  than  $1.43  for  the  cloth.  But  a  rise  of  wheat  above  $i  a  bushel  and  of 
cloth  above  $1.43  and  of  other  things  in  proportion,  could  not  take  place  without 
a  changed  relation  between  currency  and  goods,  without,  that  is,  in  this  case, 
an  inflow  of  money  metal.  A  continued  foreign  demand  for  the  now  less  produced 
wheat  might  cause  a  rapid  readjustment,  but  could  cause  such  readjustment 
only  through  purchases  of  the  wheat  (or  other  Canadian  goods),  and,  therefore, 
only  by  influencing  the  flow  of  gold. 

1  At  the  margin  of  cultivation. 

2  We  are  supposing  that  the  inflow  of  money  takes  place  to  such  an  extent 
as  to  have  this  result,  either  because  Canada  continues  to  export  wheat  until 
the  price  of  Canadian  wheat  has  thus  risen  10  per  cent,  or  because  Canadian 
exports  of  other  goods,  perhaps  goods  less  subject  to  the  competition  of  other 
sources  of  supply,  do  not  at  once  cease. 


PROTECTION  AND  NATIONAL  WEALTH       69 

goods  is  due  solely  to  the  greater  scarcity  of  those  goods 
and  the  greater  cost  of  their  production,  and  is  not  coun- 
terbalanced by  any  increase  of  money  incomes.  There 
is  here  a  net  loss.  The  country  is  poorer  because  of 
the  tax. 

If  Canada  has  an  inconvertible  paper  money,  then 
the  protective  tariff  will  have  the  same  primary  effect  but 
a  different  secondary  effect.  It  will  raise  the  price  of 
linen  from  $i  to  $1.43  without  changing  other  prices. 
There  will  be  no  increase  of  money  due  to  a  surplus  of 
exports.  Linen  will  rise  in  price  because  of  the  greater 
cost  of  production  required  and  the  greater  scarcity  of 
it  in  relation  to  other  goods  and  to  money.  But  wheat 
and,  in  general,  goods  other  than  linen  will  not  rise  in 
price.1  Instead  of  a  general  rise  in  money  prices  bring- 
ing eventual  equilibrium  by  discouraging  purchase  of 
Canadian  goods  from  abroad,  this  equilibrium  will  be 
brought  by  a  change  in  the  relative  values  of  currency,  of 
such  a  sort  that  it  requires  more  foreign  money  to  pur- 
chase a  given  amount  of  exchange  on  Canada  or  to  pur- 
chase the  gold  equivalent  of  a  given  amount  of  Canadian 
money.2 

As  we  have  already  seen,3  a  high  export  tariff  would 
act  in  a  way  directly  contrary  to  the  operation  of  pro- 
tection, on  the  flow  of  specie  and  on  money  prices  in  the 
tax-levying  country.  While  protection  causes  an  inflow 
of  specie  and  a  rise  of  money  prices,  high  export  duties 
would  cause  an  outflow  of  specie  and  a  fall  of  money 
prices.  But  in  its  effect  on  national  prosperity,  a  high 
export  tariff  would  not  require  to  be  thus  sharply  dis- 

1  Assuming  production  under  constant  cost. 

2  See  Part  I,  Ch.  VI,  §§  6,  7,  8,  9- 

8  §  i  of  this  chapter  (IV  of  Part  II). 


70     ECONOMIC  ADVANTAGES  OF  COMMERCE 

tinguished  from  protection.  It  would,  as  protection 
does,  turn  industry  out  of  its  natural  channels  into  less 
productive  channels.  The  difference  is  that,  while  the 
method  of  protection  involves  a  selection  of  industries 
to  be  established  at  the  general  expense,  a  high  export 
tariff  would  secure  the  establishment  of  new  and  less 
profitable  industries,  indirectly,  by  preventing  produc- 
tion for  export  in  the  industries  most  profitable.  Export 
restrictions  have  been  applied,  in  the  past,  along  with 
restrictions  on  imports,  to  divert  labor  from  a  relatively 
large  production  of  raw  materials,  into  the  manufacture 
of  those  materials.  England's  statutory  law,  from  the 
time  of  Edward  III  through  many  generations,  forbade 
the  export  of  sheep  or  raw  wool,  while  aiming  to  prevent 
importation  of  woolen  cloth.1  The  desire  was  to  stimu- 
late the  making  of  woolen  cloth  in  England. 

It  is  worth  pointing  out  that  a  high  tariff  levied  by 
a  country  upon  its  exports,  affects  that  country  as  to 
money  prices  and  general  prosperity,  in  the  same  way  as 
high  import  duties  levied  on  the  same  articles  of  its 
production  by  all  the  countries  with  which  it  trades. 
A  high  export  duty  levied  by  Canada  on  wheat,  would 
have  the  same  effect  as  high  import  duties  on  this  wheat 
levied  by  other  countries;  it  is  indeed  equivalent  to  a 
combination  of  all  possible  consuming  countries  to  levy 
such  an  import  duty  against  Canada.  Similarly,  a 
high  import  tax,  i.e.  a  "protective  tariff,"  is  equivalent 
to  high  export  duties  levied  by  not  one  only  but  all 
other  countries  from  which  the  taxed  goods  might  come. 

1  Levi,  The  History  of  British  Commerce,  second  edition,  London  (John  Mur- 
ray), 1880,  pp.  22,  23,  footnote;  also  Day,  A  History  of  Commerce,  New  York 
(Longmans,  Green  &  Co.)>  1907,  p.  225. 


PROTECTION  AND  NATIONAL  WEALTH      71 

§4 

Protection  to  Industries  in  which  Large  Scale  Production 
is  Advantageous 

When  a  protected  industry  is  one  of  those  in  which 
large  scale  production  is  advantageous,  there  are,  as 
regards  the  carrying  on  of  the  industry  in  the  protection- 
ist country,  two  possibilities.  The  first  possibility  is 
that  the  encouragement  and  further  extension  of  home 
production  in  that  industry  will  mean  home  production 
on  a  larger  scale  than  formerly,  i.e.  few,  if  any,  more 
plants,  but  larger  product  turned  out  by  each  plant. 
If  the  tariff  has  this  effect,  it  means  cheaper  home  pro- 
duction than  before,  and,  if  the  improvement  is  great 
enough,  cheaper  production  at  home  than  abroad.1 

The  second  possibility  is  that  the  size  of  establishment 
having  the  greatest  efficiency  is,  on  the  average,  already 

1  There  is  another  conceivable  case,  which  may  properly  be  mentioned  at  this 
point,  where  protection  might  really  increase  national  wealth.  Suppose  a  coun- 
try to  be  carrying  on  only  one  or  a  few  industries  and  to  be  the  only  country 
where  these  industries  are  carried  on.  Those  engaged  in  them,  however,  we 
shall  assume  to  be  subject  to  competition  from  others  in  their  own  country.  In 
such  a  case,  a  protective  tariff  which  should  divert  labor  into  a  line  unprofitable 
without  such  aid,  might  so  restrict  the  supply  of  the  goods  of  which  the  country 
had  a  monopoly,  as  to  raise  very  greatly  the  prices  of  those  goods  abroad  and  so 
increase  the  country's  prosperity  at  the  expense  of  foreigners.  But  unless  the 
country  had  a  monopoly  of  the  industries  from  which  labor  is  turned,  it  could 
not  appreciably  raise  the  prices  of  the  goods  by  so  doing,  for  the  competition  of 
other  sources  of  supply  would  keep  the  prices  down.  Furthermore,  unless  most 
of  the  industries  in  which  the  protectionist  country  is  engaged  are  industries 
in  which  it  has  a  monopoly,  the  establishment  of  new  industries  by  protection 
will  draw  from  other  lines  as  well  as  from  the  monopoly  lines,  and  will  therefore 
not  so  much  decrease  the  supply  of  goods  in  the  monopoly  lines  and  not  so  much 
raise  their  prices.  If  a  country  has  a  monopoly  of  only  one  or  a  few  lines  and 
those  not  important,  and  the  situation  is  almost  certain  to  be  no  more  favorable 
than  this  to  the  protectionist  country,  then  the  effect  of  protection  will  so  little 
decrease  the  supplies  of  the  monopolized  goods  as  to  have  slight  appreciable 
effect  on  their  prices.  In  short,  as  things  are  in  the  actual  civilized  world,  the 
circumstances  under  which  protection  can  be  reasonably  expected  to  increase 
national  wealth  probably  nowhere  exist. 


72     ECONOMIC  ADVANTAGES  OF  COMMERCE 

reached  before  protection  is  granted,  or,  if  it  is  not,  that 
lack  of  a  tariff  is  not  the  difficulty.  On  this  assumption, 
the  imposition  of  a  tariff  would  very  probably  result  in 
an  increase  of  the  number  of  plants  engaged  in  the  in- 
dustry within  the  protectionist  country,  but  not  in  any 
saving  through  more  efficient  plants.  By  hypothesis, 
increased  size  of  plants,  beyond  that  already  reached, 
is  no  longer  a  saving,  or  will  not  be  brought  about  by 
protection.  If  the  industry  was  being  carried  on  within 
the  country  to  any  appreciable  extent,  before  the  adop- 
tion of  a  protective  policy,  a  change  in  the  average  size 
of  establishments,  as  a  result  of  that  policy,  cannot  be 
regarded  as  assured.  In  any  case,  the  development  of 
efficiency  resulting  from  larger  scale  production  must, 
if  it  is  to  yield  any  net  gain  to  the  nation  in  question,  be 
so  great  that  the  desired  goods  can  be  secured  at  home 
more  cheaply  than  they  could  otherwise  be  imported. 
Large  scale  production  in  other  countries  and  purchase 
of  the  goods  from  them  may,  in  practice,  better  secure 
the  national  welfare. 

§5 

Protection  to  Industries  of  Increasing  Cost 

When  commodities  for  home  consumption  must  be 
produced  within  a  country  under  conditions  of  sharply 
increasing  cost  and,  because  of  limited  resources,  under 
disadvantageous  conditions  at  the  margin  of  production, 
the  opportunity  to  import  these  commodities  from  abroad 
is,  perhaps,  particularly  to  be  desired.  The  policy  of 
protection  to  the  home  production  of  such  goods  causes, 
in  the  protectionist  country,  production  at  an  increas- 
ingly greater  cost  according  as  the  protection  succeeds 
in  its  object.  Thus,  Germany's  policy  of  protection 


PROTECTION  AND  NATIONAL  WEALTH       73 

to  agriculture,  favored  by  the  owners  of  agricultural 
land,  undoubtedly  means  the  production  of  food  at  a 
progressively  higher  cost  in  proportion  as  the  protection 
is  effective.  A  high  tariff  protective  to  English  agricult- 
ure would  probably  raise  the  cost  of  food  so  high  as  to 
starve  to  death  millions  of  the  English  people.  An  anal- 
ogous consequence  follows  from  protection  to  manu- 
factures when  the  tariff  wall  safeguards  the  more  in- 
efficient plants  against  loss  from  foreign  competition, 
compelling  consumers  to  pay  prices  for  the  goods  desired, 
which  will  remunerate  the  inefficient  as  well  as  the  effi- 
cient home  producers.  Protection,  then,  forces  con- 
sumers to  get  many  of  the  goods  they  require,  at  greater 
cost,  either  because  the  production  cost  at  home  is 
uniformly  greater,  or  because  protection  compels  the 
use  of  the  poorer  soils,  the  poorer  mines,  the  poorer  sites, 
or  because  it  compels  the  giving  of  patronage  to  estab- 
lishments which  are  relatively  inefficient. 

But  may  it  not  be  desirable,  in  case  a  country  has  a 
large  export  trade  in  goods  produced  under  conditions 
of  increasing  cost,  e.g.  wheat,  to  establish  manufactures 
by  protection  in  order  to  draw  capital  and  labor  away 
from  the  poorer  or  marginal  lands  ?  Even  here  the  pro- 
tectionist policy  involves  a  loss,  though  perhaps  not  so 
great  a  loss.  It  is  only  if  and  because  even  the  poorest 
lands  in  use,  following  the  terms  of  our  illustration, 
yield  20  bushels  or  $20  a  week  in  Canada  compared  with 
a  possible  14  yards  or  $14  in  the  unprotected  linen  in- 
dustry, that  protection  is  required  to  establish  the  latter.1 
If  it  were  more  profitable  than  agriculture,  even  than 
agriculture  on  the  poorer  lands,  it  would  be  established 
without  protection.  If  it  requires  protection,  it  is  a  less 

1  Cf.  what  is  said  regarding  protection  of  this  sort,  in  Ch.  V  (of  Part  II),  §  5. 


74     ECONOMIC  ADVANTAGES  OF  COMMERCE 

profitable  business  from  the  standpoint  of  the  whole 
Canadian  people,  than  agriculture  on  the  best  available 
land  and,  therefore,  than  agriculture  on  the  poorest 
land  actually  used. 

§6 

Effect  of  a  Country's  Protective  Tariff  System  on  the  Cost 
to  it  of  Unprotected  Goods  Got  from  Other  Countries 

A  protective  policy,  however,  may  conceivably  give 
to  the  nation  which  enforces  it,  indirect  advantages 
compensating  in  part  or  in  whole  for  the  losses  incurred. 
Though  the  conditions  under  which  such  advantages 
would  be  at  all  comparable  with  the  losses,  could  seldom 
if  ever  occur  in  practice,  it  is  perhaps  worth  while  to  show 
what  these  conditions  are.  If  Canada  levies  a  high 
tariff  on  linen  from  Ireland,  and,  as  a  result,  following  the 
flow  of  gold  to  Canada,  Canadian  prices  rise  and  Irish 
prices  fall,  then  other  goods,  e.g.  laces,  silks,  etc.,  may 
be  produced  in  Ireland  more  cheaply  than  before.  In 
practice,  the  effect  would  be  more  largely  a  rise  of  Cana- 
dian than  a  fall  of  Irish  prices ;  for  the  fall  of  prices  due 
to  outflow  of  gold  must  eventually  be  distributed  over 
many  countries  and  would  be  slight  in  each,  while  the 
rise  of  prices  would  be  felt  in  Canada  alone.  But,  at 
any  rate,  since  Canadians  receive  more  for  their  wheat, 
the  silk,  etc.,  from  Ireland  (or  other  countries)  can  be 
better  afforded  than  formerly.1  If,  therefore,  the  result 
of  protection  is  that  Canada  receives  more  for  her  ex- 
ports, and,  while  shutting  out  linen,  gets  certain  other 

1  This  point  is  stated  in  relation  to  the  protective  policy  by  Taussig,  Prin- 
ciples of  Economics,  New  York  (Macmillan),  1911,  Vol.  I,  p.  525.  The  prin- 
ciple is  exactly  the  same  as  was  shown  to  apply  to  import  revenue  duties  by  Mill, 
Principles  of  Political  Economy,  Book  V,  Ch.  IV,  §  6,  and  by  Bastable,  The 
Theory  of  International  Trade,  fourth  edition,  London  (Macmillan),  1903,  p. 
118.  Cf.  also  supra,  Ch.  Ill  (of  Part  II),  §  3. 


PROTECTION  AND  NATIONAL  WEALTH       75 

foreign  goods  for  a  less  price  than  formerly,  so  getting, 
for  example,  more  silk  than  previously  for  a  given  amount 
of  wheat,  it  is  not  entirely  certain  that  Canada  has  lost 
greatly  by  her  tariff  policy. 

Needless  to  say,  this  is  not  an  argument  for  protection 
that  would  win  it  many  votes.  For  a  political  campaign 
speaker  to  tell  the  voters  of  Canada  that  a  proposed 
tariff  will  hinder  a  profitable  trade  and  prevent  their 
getting  linen  cheaply  from  Ireland,  but  that  in  conse- 
quence they  may  be  able  to  buy  silk  somewhat  more 
cheaply  than  before  in  terms  of  wheat,  would  not  be 
likely  to  arouse  any  great  enthusiasm.  A  more  prob- 
able result  would  be  a  demand  from  silk  manufacturers 
in  Canada,  or  from  would-be  silk  manufacturers,  that 
they  also  receive  protection.  The  rising  money  cost  of 
production  in  Canada,  and  the  tendency  to  falling  cost 
in  Ireland,  would  imperil  the  Canadians'  home  market. 
Especially  would  silk  manufacturers  in  Canada  be  in- 
jured, if  they  had  to  use  machinery  or  raw  material 
directly  raised  in  price  by  the  tariff  system.  But  if 
the  silk  manufacturing  and  other  lines  of  production 
should  also  be  protected,  Canada  would  no  longer  gain 
from  the  protection  of  linen  the  indirect  benefit  sug- 
gested. The  higher  money  incomes  received  in  Canada 
are  no  advantage  if  they  must  be  spent  in  Canada,  where 
prices,  counting  prices  of  protected  goods,  have  been 
raised  even  more  by  the  tariff,  than  have  money  incomes. 
A  consistently  protectionist  country  can  hope  to  realize 
this  indirect  gain  from  protection,  only  on  goods  not 
producible  at  home  and,  therefore,  not  protected.  And 
the  direct  loss  in  higher  prices  of  protected  goods  may  be 
'very  great  indeed.  As  we  have  already  seen,1  many  kinds 

1  §  2  of  this  chapter  (IV  of  Part  II). 


76     ECONOMIC  ADVANTAGES  OF  COMMERCE 

of  woolen  goods  have  been  costing  Americans  some  60 
to  70  per  cent  more  because  of  the  tariff. 

In  the  actual  commercial  world,  Canada  is  the  less 
likely  to  realize  much,  at  Ireland's  expense  (or  at  the 
expense  of  other  countries),  through  this  indirect  action 
of  the  tariff,  because  Ireland  (or  any  other  country)  has 
the  alternative  of  trading  elsewhere,  and  is  not  obliged 
to  offer  reluctant  Canada  bargains,  in  order  to  force  a 
trade,  except  as  Canada  may  have  a  substantial  mo- 
nopoly of  the  production  of  certain  goods.1  Canadians 
can  get  little,  if  any,  more  for  wheat  or  other  exported 
goods  than  before,  else  Ireland  will  refuse  to  buy.  And 
rather  than  accept  a  low  price  for  silk  and  other  goods, 
Ireland  may  sell  them  elsewhere  than  in  Canada.  It  is 
the  more  unlikely,  therefore,  that  Canada  will  gain,  thus 
indirectly,  as  much  as  she  loses  directly,  through  the  tariff. 

In  so  far  as  a  protective  policy  results  in  a  larger  quan- 
tity of  money  and  higher  money  prices  in  the  protec- 
tionist country,  it  is  likely  to  lead  to  a  demand  for  a 
progressively  higher  and  higher  tariff.  Assume,  as 
before,  a  50  cents  duty  per  yard  levied  by  Canada  on 
linen.  This  at  first  makes  linen  cloth  from  Ireland 
$1.50,  while  Canadian  cloth  can  sell  for  $1.43  and  still 
yield  as  large  a  money  return  as  the  production  of  Cana- 
dian wheat.  This  enables  a  Canadian  linen  manufac- 
turer to  undersell  his  rival  of  Ireland  by  7  cents  a  yard. 
But  the  flow  of  gold  into  Canada,  resulting  from  the 
tariff,  will  raise,  among  other  prices,  the  money  cost  of 

1  Even  without  a  monopoly,  if  Canada  supplied  so  much  of  the  wheat  used  in 
Ireland  and  other  countries  that  for  them  to  substitute  wheat  from  other  sources 
would  lower  the  margin  of  cultivation  and  raise  wheat  prices,  Canada  could  con- 
tinue to  sell  some  wheat  at  slightly  higher  prices  than  before  the  tariff  was  laid. 
There  would  remain,  however,  the  probably  much  more  important  effect  of  the 
tariff,  for  Canada,  in  the  direct  loss  caused. 


PROTECTION  AND  NATIONAL  WEALTH       77 

producing  linen.  In  Ireland,  on  the  contrary,  the  ten- 
dency will  be  towards  a  lower  cost.  Soon,  therefore,  the 
Canadian  manufacturer  may  find  that  $1.43  is  not  a 
high  enough  price,  while  the  linen  manufacturer  of  Ireland, 
even  with  the  tax,  may  sell  for  less  than  $1.50.  Unless 
the  tariff  is  further  increased,  some  linen  will  soon  be 
secured  from  Ireland ;  there  will  no  longer  be  a  net  flow 
of  gold  into  Canada ;  and  Canadian  prices  will  no  longer 
rise  as  compared  with  Irish  prices.  Or,  as  we  have  seen, 
the  same  result  is  reached  by  Canadian  purchase  of  other 
Irish  goods.  Suppose,  however,  that  the  Canadian  tariff 
is  progressively  raised  so  as  to  maintain  the  7  cent  mar- 
gin, and  is  raised  on  other  Irish  goods  as  well,  and  suppose 
that  Ireland's  demand  for  Canadian  goods  is  not  checked 
until  money  in  Canada  is  -9°-  of  its  former  amount  and 
in  Ireland  slightly  less  than  before.  Then,  assuming 
conditions  of  approximately  constant  cost,  Canadian 
wheat  will  sell  for  about  $1.10  a  bushel  and  Canadian 
linen  for  $1.57,  while  linen  made  in  Ireland  will  sell, 
not  counting  the  tariff,  for  slightly  less  than  $i  (not 
much  less,  since  any  considerable  fall  of  prices  in  Ireland 
would  cause  an  inflow  of  specie  from  Germany,  France, 
and  elsewhere,  so  distributing  over  many  countries  the 
effect  of  the  outflow  of  money  to  Canada).  To  give 
Canadian  producers  a  7  cents  margin,  the  tariff  will  now 
have  to  be  so  high  that  linen  made  in  Ireland  can  sell, 
in  Canada,  for  not  less  than  $1.64.  Since  this  linen 
sells,  without  the  tariff,  for  $i  or  less,  the  tariff  will  have 
to  be  $0.64  a  yard  1  instead  of  the  original  $0.50.  Even  a 
tariff  to  "equalize  the  cost  of  production"  would  need, 
after  this  change  in  relative  amounts  of  money,  to  be 
$0.57  instead  of  $0.43. 

1  We  are  here  neglecting  cost  of  transportation. 


78     ECONOMIC  ADVANTAGES  OF  COMMERCE 

But  it  must  not  be  supposed  that  continuous  extension 
and  increase  of  its  tariff  wall  can  raise  prices  in  a  country 
without  limit.  Even  if,  as  prices  in  Canada  rise  and  in 
Ireland,  or  elsewhere,  fall,  protection  is  given  to  each 
article  subject  to  foreign  competition,  which  can  be  made 
in  Canada,  and  even  if  this  protection  is  progressively 
raised  so  as  to  prevent  any  purchase  abroad  by  Cana- 
dians as  their  money  incomes  increase,  —  in  short,  even 
if  all  importation  of  goods  is  effectively  prohibited,  the 
rise  of  prices  in  Canada  will  nevertheless  eventually 
reach  a  limit.  For,  sooner  or  later,  Canadian  prices  will 
get  so  high  that  no  goods  whatever  will  be  purchased  in 
Canada  by  people  in  foreign  countries. 

All  these  conclusions  are  the  same,  except  as  to  nominal 
prices,  if  we  suppose  Canada's  currency  system  unrelated 
to  those  of  other  countries.  A  high  tariff  would  not 
then  raise  Canadian  money  prices,  but  it  would  change 
the  relative  value  of  Canadian  and  other  monetary  stand- 
ards so  as  to  make  purchase  of  Canadian  goods  more 
expensive  to  other  countries  in  terms  of  their  own  money. 
This  fact  has  been  frequently  pointed  out  in  preceding 
pages.  Here  it  is  to  be  emphasized  that  it  means  cheaper 
purchase  of  foreign  goods  in  terms  of  Canadian  goods. 
A  smaller  amount  of  Canadian  money  than  before  will 
buy  drafts  on  foreign  countries  for  more  foreign  money 
and,  therefore,  goods  than  before,  or  will  buy  the  gold 
equivalent  of  more  foreign  money  and  goods  than  before. 
Hence,  Canadians  are  tempted,  unless  prevented  by  a 
tariff,  to  buy  foreign  goods  which  they  did  not  previously 
buy  and  even,  unless  the  tariff  protection  is  increased, 
to  buy  goods  on  which  the  protection  seemed,  at  first, 
adequate  (though  not  excessive) . 


PROTECTION  AND  NATIONAL  WEALTH       79 

§7 

A  Tariff  "Equal  to  the  Difference  in  Cost  of  Production 
at  Home  and  Abroad,  together  with  a  Reasonable  Profit'1 

In  view  of  these  facts,  together  with  the  fact  that  the 
same  kinds  of  goods  are  produced  simultaneously  at 
different  costs,  the  proposition,  prominently  put  forth 
in  recent  politics,  to  establish  a  tariff  which  shall  "  equal 
the  difference  in  the  cost  of  production  at  home  and 
abroad,  together  with  a  reasonable  profit,"  1  is  chimeri- 
cal. There  is  no  fixed  difference,  independent  of  the  tariff, 
in  the  home  and  foreign  costs  of  production.  For  the 
difference  in  these  costs  is  dependent,  to  some  degree, 
on  the  relative  levels  of  prices  at  home  and  abroad, 
which  are  affected  by  the  flow  of  gold,  which  is,  in  turn, 
at  least  in  some  degree  affected  by  the  tariff.  The  tariff 
itself,  that  is,  helps  to  cause  the  very  difference  in  cost 
of  production  which  is  set  forth  as  a  justification  for  it. 
As  we  have  seen  in  our  illustration,  a  tax  of  43  to  50  cents 
per  yard  may  be,  at  the  start,  the  amount  necessary  to 
equalize  cost  of  production  in  the  protectionist  and  other 
countries,  and  yield  a  " reasonable"  profit;  yet  later,  if 
a  protective  tariff  policy  has  been  followed,  a  higher  tax 
than  43  cents  may  seem  equally  necessary  to  equalize 
conditions,  and  this  just  because  the  tariff  itself  has 
widened  the  cost  difference.  In  addition,  the  cost  of 
production  may  be  directly  increased  by  tariff  duties  on 
the  machinery  and  raw  materials  of  industry. 

Again,  "cost  of  production,"  if  not  further  defined, 
may  be  taken  to  mean  marginal  cost,  average  cost,  or 
cost  under  the  most  favorable  circumstances.  Is  a  tariff 

1  Republican  party  platform  of  1908,  Republican  Campaign  Text-Book,  1908, 
p.  462. 


8o     ECONOMIC  ADVANTAGES  OF  COMMERCE 

which  equals  the  difference  in  cost  of  production  at  home 
and  abroad,  to  be  high  enough  adequately  to  protect 
the  marginal  producer,  or  the  average  producer,  or  only 
the  producer  best  situated?  In  manufacturing,  is  it 
to  protect  the  struggling  factory  hardly  able  to  maintain 
itself,  or  only  the  most  efficient  ?  If  protection  is  to  be 
given  to  the  producer  under  greatest  difficulties  and  to 
the  most  inefficient  producer,  the  burden  on  consumers 
may  be  very  great.  Furthermore,  inefficiency  is  in  some 
degree  encouraged,  instead  of  being  weeded  out.  The 
recent  Tariff  Board  found  in  the  cotton  manufacturing 
industry  of  the  United  States  not  only  modern  estab- 
lishments, but  also  some  of  low  efficiency  and  considerable 
antiquity.1  Some  6o-year  old  spinning  and  weaving 
machinery  was  still  in  use.  A  system  which  protects 
producers  the  more  highly  the  less  efficient  they  are, 
though  promulgated  as  a  "scientific"  solution  of  the 
tariff  problem,  would  seem,  in  view  of  these  considera- 
tions, very  far  from  being  such  a  solution.  If,  on  the 
other  hand,  the  protection  is  intended  only  to  equalize 
conditions  for  the  average  or  best  producers,  as  opposed 
to  foreign  competitors,  there  is  still  a  loss  to  consumers, 
and  there  is  also  the  objection,  from  the  protectionist 
point  of  view,  that  such  a  policy  would  leave  without 
adequate  protection  the  very  producers  most  needing 
help. 

§8    , 

Relative  Advantages  in  the  World's  Commerce  of  Countries 
having  High  and  Countries  having  Low  or  No  Tariffs 

Before  closing  our  discussion  of  protective  tariffs  in 
relation  to  national  prosperity,  there  is  one  general  truth 

1  Report  of  the  Tariff  Board  on  Schedule  I  of  the  Tariff  Law,  Vol.  2,  p.  416. 


PROTECTION  AND  NATIONAL  WEALTH   81 

to  which  we  may  properly  give  special  emphasis.  This 
truth  is  that,  among  a  number  of  trading  countries,  those 
with  low  or  with  no  tariff  restrictions  have  the  least  to 
lose.1  If,  for  example,  Great  Britain  alone  adheres  to 
the  principles  of  free  trade,  while  all  other  nations  main- 
tain high  import  duties  (or  high  export  duties,  or  both), 
then  Great  Britain's  position  in  trade  is  relatively  the 
best.  In  the  first  place,  purchasers  in  all  other  coun- 
tries will  buy  of  Great  Britain  rather  than  of  countries 
where  the  large  quantity  of  money  due  to  protection  (or 
where  high  export  duties,  if  such  were  common)  makes 
prices  of  goods  exported  by  them  high ;  and  this  very 
turning  of  the  demand  to  Great  Britain  will  enable 
British  producers  to  get,  for  what  goods  they  are  able, 
despite  foreign  protective  tariffs,  to  export,  higher  prices 
than  if  their  rivals  in  selling  each  special  kind  of  goods 
in  a  given  market,  were  similarly  untrammelled.  In 
the  second  place,  sellers  of  goods  produced  in  all  other 
countries,  being  unable  to  sell  so  easily  and  profitably 
to  countries  maintaining  protective  tariffs  against  them 
(or  to  countries,  if  there  were  any  such,  whose  export 
tariffs  make  their  home  prices  low),  will  be  the  more 
anxious  to  sell  all  they  can  in  Great  Britain ;  and  they 
will  make  even  lower  prices  in  selling  to  Great  Britain 
than  otherwise  they  would,  because  it  is  so  difficult  to 
secure  a  market  and  to  sell  at  a  profit,  anywhere  else. 
Protectionist  writers  have  sometimes  hinted  that  free 
trade,  or  tariff  for  revenue  only,  might  be  very  good  if 
all  nations  practised  it,  but  that  so  long  as  other  coun- 
tries practise  protection,  we  must  do  so  in  self-defence. 
The  truth  is  that  the  best  possible  way  for  a  nation  to 
adapt  itself  to  the  conditions  caused  by  the  bad  policy 

1  Cf.  Bastable,  The  Theory  of  International  Trade,  p.  122. 
PART  H  —  G 


82     ECONOMIC  ADVANTAGES  OF  COMMERCE 

(e.g.  protective  tariffs)  of  the  others,  is  to  avoid  imitating 
that  bad  policy.  Then  it  has  an  advantage  over  these 
others  and  gains  trade  and  profit  which  they  cannot.1 

It  does  not  follow  that  Great  Britain  is  better  off  be- 
cause other  nations  have  high  duties.  So  far  as  other 
countries  become  self-sufficient  by  means  of  their  tariffs, 
Great  Britain  also  may  be  forced  to  be  more  self-sufficient 
than  would  otherwise  be  necessary.  But  so  far  as  some 
trade  still  persists,  despite  these  interferences,  Great 
Britain  has  an  advantage  in  getting  it  and  in  gaining 
from  it,  over  all  the  others.  Each  country's  tariff  lessens 
Great  Britain's  trade  with  that  country  and  so  tends  to 
decrease  the  wealth  of  both  Great  Britain  and  the  country 
levying  the  tariff.  But  each  country's  tariff  hurts  that 
country  as  a  competitor  of  Great  Britain  in  trade  with 
third  and  fourth  countries,  and  so  gives  Great  Britain 
an  advantage  over  it. 

Largely,  we  may  reasonably  suppose,  through  the 
operation  of  these  principles,  the  foreign  commerce  of 
the  United  Kingdom  long  since  reached  a  volume  which 
that  of  none  of  her  protectionist  rivals  has  yet  been  able 
to  attain.  Not  only  do  the  people  of  the  British  Isles 
trade  extensively  with  the  English-speaking  peoples  of 
their  own  colonies  and  with  the  United  States,  but  their 
commerce  is  the  greatest  with,  for  example,  most  of  the 
South  American  republics,2  as  well  as  with  many  other 
countries.  Their  ships  plough  the  remotest  seas  and  carry 
the  products  of  English  mines  and  factories  to  parts  of 
the  earth  almost  unknown  to  American  exporters.  Like- 
wise, from  all  parts  of  the  world  come  the  raw  materials, 

1  Cf.  Sumner,  Protectionism,  New  York  (Holt),  1885,  pp.  138,  139. 

2  See  comparative  statistics  in  any  of  the  recent  annual  reports  on  Commercial 
Relations  oj  the  United  States. 


PROTECTION  AND  NATIONAL  WEALTH       83 

the  food  supplies  and  other  goods,  which  the  British 
people  require  and  which  they  can  buy  more  cheaply 
abroad  than  they  can  produce  at  home.  Raw  cotton 
they  get  from  the  United  States,  from  Egypt,  from 
India,  to  be  reshipped  to  South  America  and  elsewhere 
as  cotton  fabrics,  or  to  be  made  up  into  wearing  ap- 
parel for  themselves.  Wheat  they  secure  from  the 
United  States,  Canada,  Argentina,  and  other  countries, 
and  they  secure  it,  we  must  conclude,  all  the  more 
cheaply  because  some  of  the  European  nations  restrict 
its  importation  by  means  of  protective  duties.  Wool  is 
available  particularly  in  South  America  and  in  Australia. 
In  short,  the  whole  world  is  a  British  market  so  far  as 
the  British  people  can  make  it  so,  and  from  countries 
near  and  far  they  draw  the  riches  which  other  nations, 
by  foolish  tariff  restrictions,  shut  away.- 

§9 

Summary 

The  general  conclusion  of  this  chapter  is  that  a  pro- 
tective tariff  reduces,  and  may  reduce  considerably, 
the  total  wealth  of  the  country  which  adopts  it.  By  as 
much  as  it  hinders  imports,  by  so  much  it  must,  in  the 
long  run,  interfere  with  the  development  of  an  export 
trade.  It  diverts  the  productive  force  of  a  country  from 
lines  in  which  it  is  relatively  effective  to  lines  in  which  its 
effectiveness  is  less.  Even  if  those  who  are  protected 
gain  some  benefit  from  the  policy,  they  gain  less  than 
others  in  the  country  lose.  Protection  tends  to  raise  all 
money  prices,  including  money  incomes,  in  the  protected 
country.  But  there  is  a  special  rise  of  price  of  protected 
goods,  not  balanced  by  any  rise  of  money  incomes. 


84     ECONOMIC  ADVANTAGES  OF  COMMERCE 

Therefore,  prices  of  goods  rise,  on  the  average,  more  than 
money  incomes,  and  the  general  prosperity  is  reduced. 
It  is  conceivable,  but  improbable,  that  protection  of 
some  industries  may  result  in  larger  establishments 
within  the  protectionist  country  and  a  gain  in  efficiency 
enough  to  make  home  production  as  cheap  as  foreign. 
When  an  industry  of  increasing  expense  (diminishing 
returns)  is  protected,  the  injurious  effects  on  national 
prosperity  are  the  greater,  the  more  the  tariff  extends 
the  industry.  Protection  may  give  to  a  country  indirect 
advantages  in  the  form  of  better  rates  of  interchange 
on  other,  unprotected  goods,  but  this  gain  is  not  likely 
to  be  great,  since  other  countries  have  the  option  of 
trading  elsewhere  than  with  the  protectionist  country. 
If  such  a  gain  were  likely  to  be  realized,  there  would 
probably  be  a  demand,  in  the  protectionist  country, 
for  the  taxation  of  imports  of  these  other  goods  in  so 
far  as  they  could  be  produced  at  home,  and  so  a  partial 
prevention  of  the  gain. 

If  protection  is  applied  moderately  but  upon  many 
goods,  so  that  the  scale  of  prices  in  the  protectionist 
country  rises  compared  with  others,  even  some  of  the 
protected  goods  may  come  to  be  imported  to  some  extent 
from  countries  whose  prices  have  not  thus  been  artifi- 
cially raised.  If  so,  there  is  likely  to  be  a  demand  for 
further  protection^  The  proposition  to  levy  a  tariff 
which  shall  be  equal  to  the  difference  in  cost  of  produc- 
tion in  the  protected  country  and  abroad,  overlooks  the 
fact  that  this  difference  in  cost  is,  to  some  extent,  a 
consequence  of  high  protection.  It  overlooks,  also,  the 
fact  that  cost  is  not  the  same  in  all  establishments  or  on  all 
sites,  within  a  single  country. 

Despite  the  frequent  claim  of  some  protectionists  that 


PROTECTION  AND  NATIONAL  WEALTH      85 

any  one  country  must  adopt  a  protective  tariff  system 
because  others  do,  the  truth  is  that  a  country  which, 
among  others  having  high  import  duties  (or  export  duties 
or  both),  maintains  free  trade  or  only  low  tariffs,  has  an 
advantage,  because  of  this  policy,  over  all  the  others. 


CHAPTER  V 

THE  EFFECTS  OF  PROTECTION  ON  THE  DISTRIBUTION  OF 
NATIONAL  WEALTH  AMONG  ECONOMIC  CLASSES  AND 
TERRITORIAL  SECTIONS 

§i 

Effect  of  Protection  on  the  Rate  of  Interest  and  Therefore 

on  Wages 

IN  discussing  the  effects  of  a  protective  tariff  on  the  dis- 
tribution of  wealth  and  income  among  economic  classes, 
it  is  important  that  we  have  in  mind  some  idea  of  the 
laws  according  to  which  wealth  and  income  are  divided. 
The  benefits,  or  the  wealth  and  income,  resulting  from 
production  are  said  to  be  divided  among  capitalists, 
laborers,  and  land  owners.  Capitalists  receive  interest ; 
laborers  receive  wages ;  land  owners  receive  rent. 

Interest  arises,  in  large  part,  from  the  surplus  pro- 
ductivity of  indirect  or  roundabout  production,  over 
direct.1  Men  can  produce  consumers'  wealth  and  in- 
come by  applying  labor  with  the  aid  of  existing  machin- 
ery, or  they  can  devote  time  to  increasing  the  amount 
of  machinery  in  order  to  get,  later,  larger  results.  The 
second  method  is  more  indirect  or  roundabout.  It 

1  It  is  not  claimed  that  the  theory  of  interest  as  here  briefly  stated  is  com- 
plete, or  anything  but  a  working  theory  sufikient,  perhaps,  for  the  requirements 
of  this  chapter.  The  subject  of  interest  is  so  interwoven  with  other  economics, 
that  it  cannot  be  satisfactorily  treated  in  a  few  paragraphs.  The  critical  reader 
is  referred  to  the  writer's  article  in  the  Quarterly  Journal  of  Economics,  August, 
1913,  entitled  "The  Marginal  Productivity  versus  the  Impatience  Theory  of 
Interest,"  and  to  a  later  article  in  The  American  Economic  Review,  June,  1914. 
on  "The  Discount  versus  the  Cost  of  Production  Theory  of  Capital  Valuation." 

86 


PROTECTION  AND  DISTRIBUTION  87 

yields,  in  general,1  a  surplus  product  over  what  can  be 
secured  by  the  more  direct  method.  But  roundabout 
production,  i.e.  production  by  first  making  tools,  ma- 
chinery, etc.,  yields  a  smaller  surplus  the  further  it  is  ex- 
tended. The  more  tools,  machinery,  and  other  capital 
equipment  we  have  (after  a  certain  point  is  reached) ,  the 
less  desirable  is  it  further  to  increase  this  equipment. 
The  gain  or  surplus  from  so  doing  becomes  smaller  and 
smaller,  yet  for  a  long  time,  perhaps  indefinitely,  remains 
a  gain. 

But  thus  to  extend  the  roundaboutness  of  production 
requires  a  supply  of  goods  for  the  present  maintenance 
of  those  occupied  in  constructing  the  necessary  capital, 
since  they,  being  engaged  in  roundabout  production, 
cannot  secure  this  present  maintenance  from  their 
present  labor.  Possession  of  goods  which  may  serve  as 
means  of  maintenance  for  laborers  during  the  roundabout 
production  process,  enables  production  to  be  carried  on 
thus  indirectly  with  the  consequent  larger  product. 
For  this  reason,  a  surplus  in  future  goods  will  be  paid 
for  a  given  amount  of  present  goods ;  $100  to-day  may 
buy  $105  next  year,  for  $100  to-day  makes  it  possible  to 
turn  away  from  production  for  immediate  needs  and  to 
produce,  by  the  usually  larger  yielding  indirect  method, 
for  the  future.  For  the  use  of  the  present  consumable 
goods  which  make  indirect  production  possible,  a  pre- 
mium will  be  paid  by  those  desiring  control  of  the 
present  goods;  and  this  premium  will  depend  on  the 
gain  which  indirect  production  yields.  The  possessors 
of  command  over  present  goods,  on  the  other  hand,  will 
not  trade  them  for  future  goods  except  for  a  premium, 

1  Not  necessarily,  but  unless  the  indirect  process  is  expected  to  yield  more,  it 
will  not  be  adopted. 


88     ECONOMIC  ADVANTAGES  OF  COMMERCE 

because  these  present  goods  can  be  used  in  support  of 
themselves  and  those  they  hire  and  so  can  make  it  possible 
for  them  to  engage  in  roundabout  production  and  reap 
the  surplus.  To  dispose  of  their  command  over  present 
goods  is,  in  so  far,  to  give  up  this  possibility,  and  they 
will  not  give  it  up  without  compensation.  The  rate  of 
interest,  then,  is  determined,  on  both  the  supply  and 
demand  sides  of  the  market,  — the  side  of  those  who  want 
and  that  of  those  who  have  command  over  present  goods, 
—by  the  rate  of  surplus  productivity1  of  roundabout  over 
more  direct  production. 

To  recapitulate,  the  more  largely  production  is  round- 
about or  capitalistic,  the  larger  is  the  total  amount  of 
wealth  and  income  yielded ;  the  more  largely  production 
is  capitalistic,  the  less  additional  gain  is  realized  by  the 
further  extension  of  roundabout  production ;  the  greater 
the  accumulations  of  society,  and  the  further  indirect 
production  is  extended,  the  lower  (other  things  equal) 
is  the  rate  of  interest.  Large  accumulations  and  great 
extension  of  roundabout  production  make  social  wealth 
greater,  the  rate  of  interest  lower,  the  rate  of  wages 
higher.  We  saw,  in  the  last  chapter,  that  a  protective 
tariff  tends  to  decrease  the  productive  efficiency  of  a 
country  which  applies  it.  Such  a  tariff  makes  more 
difficult  the  process  of  accumulation.  It  tends  somewhat 
to  lessen  the  degree  of  roundaboutness  in  production,  to 
lessen  the  extent  to  which  production  is  capitalistic. 
Protection,  therefore,  because  it  lessens  national  wealth 
through  turning  industry  into  less  profitable  channels, 
may  lessen  national  wealth  further  by  making  production 
less  capitalistic.  If  it  does  this,  it  will  tend  to  raise  the 
rate  of  interest,  though  not  necessarily  the  total  amounts 

1  At  the  margin  of  indirect  production. 


PROTECTION  AND  DISTRIBUTION  89 

received  as  interest  since  the  higher  rate  will  be  on  smaller 
capital ;  while  it  will  tend  to  reduce  wages  both  by  giving 
to  capitalists  a  larger  proportion  of  the  results  of  round- 
about production  and  by  making  production,  on  the 
whole,  less  roundabout  and,  therefore,  less  efficient. 
This  indirect  effect  which  a  protective  tariff  may  have  on 
wages,  through  its  effect  on  accumulation  and  the  rate 
of  interest,  is  without  doubt  very  much  less  important 
than  the  more  direct  effect  to  be  next  discussed,  but 
its  operation,  so  far  as  it  does  affect  wages,  is  unfavorable. 

§2 

Brief  Statement  of  Laws  of  Wages  and  Land  Rent 

The  general  level  of  wages  is  determined,  like  other 
prices,  by  supply  and  demand.  The  wages  which  will 
equalize  supply  of  and  demand  for  labor  will  be  higher 
or  lower  according  as  labor  is  more  or  less  productive. 
Should  the  productivity  of  labor  double,  wages  would 
double.  For  if  labor  would  produce  twice  as  much  as 
before  and  wages  did  not  rise  correspondingly,  the  profit 
to  be  realized  in  hiring  labor  would  be  very  great.  This 
would  increase  the  demand  for  labor  until,  if  wages  did 
not  rise,  demand  would  exceed  supply.  Hence,  wages 
must  rise  and  must  rise  in  proportion.  We  have  refer- 
ence here  to  real,  as  distinguished  from  money,  wages; 
that  is,  to  the  necessaries,  comforts,  and  luxuries  which 
wage  earners  receive,  rather  than  to  the  mere  number  of 
dollars. 

If  all  land  were  equally  fertile  and  all  sites  equally 
good,  and  if  desired  land  and  space  were  unlimited,  wages 
would  equal  the  whole  product  of  labor  except  interest. 
Those  who  advanced  the  means  required  to  make  pro- 


go     ECONOMIC  ADVANTAGES  OF  COMMERCE 

duction  more  roundabout,  would  enjoy  interest ;  beyond 
this,  labor  would  get  the  entire  product  of  industry. 
But  all  land  is  not  equally  fertile ;  all  sites  are  not  equally 
satisfactory ;  land  and  space  are  not  unlimited ;  and 
there  is  to  be  reckoned  with,  the  great  law  of  diminish- 
ing returns.  Whether  in  agriculture,  manufacturing,  or 
other  work,  an  increase  of  labor  upon  any  given  space  or 
area  will  not,  beyond  a  certain  point,  result  in  a  pro- 
portionate increase  of  the  product.  Two  men,  on  a  100- 
acre  farm,  may  secure  twice  or  more  than  twice  as  great 
a  result  as  can  one.  But  it  is  pretty  certain  that  two 
hundred  men,  working  on  that  farm,  will  not  secure  100 
times  as  large  a  product  as  can  two  men.  So,  in  manu- 
facturing, a  point  of  maximum  economy  is  reached, 
beyond  which  it  does  not  pay  to  crowd  men  together  on  a 
limited  area  or  to  build  story  upon  story,  but  beyond 
which  larger  production  requires  more  land.  Since  all 
land  is  not  equally  good,  this  means  that  larger  production 
requires  the  use  of  less  productive  land  and  sites  than 
would  otherwise  have  to  be  used. 

To  illustrate  the  bearing  of  these  facts  upon  the  theory 
of  wages  and  rent,  let  us  consider  the  case  of  a  loo-acre 
farm.  Upon  it,  two  men  might  be  able  to  produce  wheat 
at  the  rate  of  3120  bushels  a  year  or  an  average  of  60 
bushels  a  week,  three  men  an  average  of  85  bushels  a 
week,  four  men  105  bushels,  five  men  120  bushels.  Then 
the  third  man  adds  25  bushels  to  the  product  which  would 
result  from  two  men's  work ;  the  fourth  man  would  add 
20  bushels;  the  fifth,  15  bushels.  Suppose  that  wheat 
is  $i  a  bushel.  Then,  if  wages  are  not  more  than  $25 
a  week  but  are  enough  less  to  pay  interest  on  the  wages 
advanced,  the  owner  of  the  land  will  hire  three  men  to 
cultivate  it.  He  will  not  hire  a  fourth,  since  a  fourth  will 


PROTECTION  AND  DISTRIBUTION  91 

add  but  20  bushels,  worth  $20,  to  the  product.  If, 
however,  wages  are  slightly  less  than  $20  a  week,  he  will 
hire  four  men;  and  if  they  are  slightly  less  than  $15, 
he  will  employ  five.  The  higher  wages  are,  the  fewer 
men  he  will  employ.  The  lower  wages  are,  the  more  men 
he  will  employ.  This  is  true  of  all  employers.  Some 
land  is  so  poor  that  no  one  can  afford  to  work  it  or  hire 
others  to  work  it,  if  wages  are  high.  If  wages  are  low, 
this  land  can  be  worked  profitably.  In  general,  the 
lower  wages  are,  the  greater  is  the  demand  for  labor. 
More  men  are  desired  on  the  more  productive  sites  and 
men  are  desired  for  the  utilization  of  sites  that  otherwise 
would  stand  undeveloped.  At  any  level  of  wages, 
employers  will  hire  men  up  to  the  point  where  the  last 
man  hired  just  produces  his  wages  or  just  produces  his 
wages  plus  interest. 

To  the  extent  that  industry  is  carried  on  under  nearly 
constant  cost,  a  great  amount  of  labor  can  be  employed 
at  wages  almost  as  high  per  man  as  would  be  paid  to  a 
smaller  number  of  laborers.  Very  little  reduction  of 
wages  is  required  to  increase,  greatly,  the  demand  for 
labor,  since  many  employees  can  be  hired  before  the 
worth  of  the  last  man  (the  marginal  product  of  labor), 
becomes  less  than  his  wages.  If,  on  the  other  hand, 
industry  is  carried  on  under  conditions  of  sharply  in- 
creasing labor  cost  (diminishing  returns),  any  consider- 
able increase  in  the  demand  for  labor  (other  things  equal), 
will  not  take  place  except  at  greatly  reduced  wages.  If, 
therefore,  the  industry  of  a  country  is  forced  into  a  line 
of  sharply  increasing  labor  cost,  real  wages  must  become 
lower ;  though  it  is  likewise  true  that  if  industry  is  forced 
into  a  line  of  constant  labor  cost  into  which  it  would  not 
naturally  go,  real  wages  will  probably  become  lower.1 

1  See  §  5  of  this  chapter  (V  of  Part  II). 


92      ECONOMIC  ADVANTAGES  OF  COMMERCE 

Ignoring  interest,  the  law  of  which  we  have  already 
stated,  the  surplus  of  production  above  the  amounts  paid 
as  wages  constitutes  land  rent  and  goes  to  the  owners  of 
land.  In  our  illustration,  at  wages  of  $20  a  week  or 
slightly  less,  not  more  than  four  men  would  be  employed 
on  the  given  farm.  No  one  of  them  would  be  employed 
at  more  than  $20  wages,  because  no  one  of  the  four  adds 
more  than  20  bushels  or  $20  to  what  the  product  would 
be  without  him.  The  weekly  wages  of  all  four  will  not, 
therefore,  exceed  $80.  The  total  product,  however,  with 
four  men  working,  is  105  bushels  or  $105  worth.  This 
leaves  $25  a  week  as  land  rent  to  the  owner  of  the  farm. 
If  wages  were  lower,  not  only  would  more  men  be  em- 
ployed, but  rent  would  be  higher.  If  wages  were  higher, 
fewer  men  would  be  employed  and  rent  would  be  lower. 
Some  land  will  yield  higher  rent ;  some  is  so  poor  as  to 
yield  no  rent. 

When  protection  turns  the  industry  of  a  country  into 
a  line  which  it  otherwise  would  not  follow,  the  rents  of 
lands  or  sites  required  in  this  line  tend  to  rise,  and  the 
owners  of  these  lands  and  sites  become  more  prosperous. 
On  the  other  hand,  the  rents  of  lands  or  sites  which  were 
used  in  the  lines  from  which  industry  has  been  turned, 
tend  to  fall,  and  the  owners  of  these  lands  and  sites 
become  less  prosperous.  Our  task  is  to  inquire  what,  in 
general,  is  the  effect  of  protection  on  the  total  rent  pay- 
ments and  on  the  general  level  of  real  wages  in  the 
protectionist  country. 


PROTECTION  AND  DISTRIBUTION  93 

§3 

The  Effect  of  Protection  on  Wages  when  Protected  and  Un- 
protected Goods  are  Produced  in  the  Protectionist  Coun- 
try, under  Conditions  of  Substantially  Constant  Cost 

Let.  us,  to  begin  with,  consider  the  effect  of  protection 
on  wages,  when  both  protected  and  unprotected  goods 
are  produced,  in  the  protectionist  country,  under  condi- 
tions of  substantially  constant  cost.  Under  these  condi- 
tions, a  tariff  will  not  greatly  affect  land  rent.  The  first 
effect  of  protection  is,  as  we  have  seen,1  to  raise  the  prices 
of  protected  goods  by  not  more  than  the  amount  of  the 
tariff,  without  affecting  money  wages.  The  secondary 
effect  of  protection,  resulting  from  the  inflow  of  money 
(so  far  as  protection  occasions  such  an  inflow),  is  to  raise 
prices  of  unprotected  goods  and  money  wages,  and  to 
further  raise  the  prices  of  protected  goods.  Canada's 
protective  tariff  on  linen  has,  as  its  first  effect,  a  43  cents 
or  a  43  per  cent  rise  in  price  per  yard,  wages  remaining  the 
same,  viz.  about  $20  a  week  (a  week's  labor  producing 
20  bushels  of  wheat  worth  $i  a  bushel).  The  second 
effect  may  be  to  raise  everything  10  per  cent.  If,  under 
conditions  of  constant  cost  in  all  lines,  there  is  such  a 
general  rise  of  prices  due  to  money  inflow,  we  must 
suppose  that,  until  this  rise  reaches  10  per  cent,  there  will 
be  some  Canadian  goods  still  sufficiently  in  demand  else- 
where to  maintain  the  inflow  of  gold,  though  wheat, 
because  of  competition  from  other  sources,  may  not  be 
such  a  good.  Assuming  such  an  average  secondary 
rise  of  10  per  cent,  and  that  all  goods  are  produced  under 
conditions  of  constant  cost,  this  rise  must  affect  any  one 
kind  of  goods,  e.g.  wheat.  Otherwise,  those  producing 

i  See  Ch.  IV  (of  Part  II),  §§  i  and  2. 


94    ECONOMIC  ADVANTAGES  OF  COMMERCE 

that  kind  of  goods  will  turn  to  some  other  line.  If  wheat 
cannot  be  exported  at  the  higher  price,  only  enough  will 
be  produced  for  home  consumption,  and  the  other  wheat 
producers  will  become  linen  producers,  etc.  Then  the 
total  increase  of  wheat  in  price  is  10  per  cent,  and  of 
money  wages  10  per  cent,  but  of  linen  57  per  cent  (43 
per  cent  and  10  per  cent  more  added  to  the  new  price 
of  $1.43  makes  $1.57).  Obviously,  the  average  wage 
earner's  condition  is  worse  because  of  the  tariff,  even 
though  his  money  wages  are  somewhat  higher  than 
otherwise  they  would  be.  If  the  protectionist  country 
has  an  inconvertible  money  system  unrelated  to  foreign 
systems,  money  wages  and  unprotected  goods  will  remain 
the  same  in  price  as  before,  while  protected  goods  rise 
in  price.  Wage  earners  will  be  worse  off.  With  a  com- 
mon money  standard,  gold,  for  the  countries  trading, 
prices  in  the  protectionist  country,  even  of  unprotected 
goods,  rise,  and  wages  rise  in  the  same  proportion ;  but 
since  wages  rise  in  no  greater  proportion,  and  since 
protected  goods  do  rise  in  price  by  a  greater  proportion, 
real  wages  are  lower.1 

Our  conclusion  as  to  money  wages  is  only  that  a  high 
tariff  will  tend  to  make  them  higher  in  a  given  country 

1 A  restrictive  duty  on  the  export  of  wheat  would  cause  an  outflow  of  gold 
and  a  fall  in  the  general  level  of  prices  but  would  likewise  reduce  real  wages. 
The  decreased  market  for  wheat  would  lower  its  price  in  Canada  and  would 
lower  in  the  same  degree  (assuming  it  to  be  produced  under  conditions  of  con- 
stant cost)  the  money  wages  of  producers.  But  the  price  of  linen,  into  the  pro- 
duction of  which  Canadian  labor  might  in  considerable  degree  be  eventually 
forced,  could  not,  since  Canada  is  at  a  relative  disadvantage  in  its  production, 
fall,  to  the  same  extent,  below  the  price  at  which  it  was  previously  imported. 
At  that  price,  outflow  of  money  for  linen  would  cease.  Under  the  conditions 
of  production  assumed,  Canadians  could  better  afford  to  produce  wheat  even 
for  but  70  cents  a  bushel  than  to  produce  linen  for  appreciably  less  than  $i  a 
yard.  Twenty  bushels  at  70  cents  a  bushel  or  14  yards  at  $i  a  yard  would  alike 
yield  but  $10  a  week.  A  week's  wages  would  buy  as  much  wheat  as  before  but 
less  linen.  Hence,  real  wages  would  be  lower  because  of  such  a  tax. 


PROTECTION  AND  DISTRIBUTION  95 

than  they  would  be  in  that  same  country  in  the  absence 
of  the  tariff.  It  does  not  follow  that  money  wages  will 
be,  necessarily,  higher  in  a  protectionist  country  than  in 
a  free  trade  country.  In  a  prosperous  country,  money 
wages  as  well  as  real  wages  will  be,  other  things  equal, 
higher  than  in  a  country  not  prosperous.  In  the  United 
States,  for  example,  average  money  wages,  as  well  as 
average  real  wages,  are  higher  than  in  Europe.  This  is 
due  to  the  fact  that  in  many  lines  we  have  great  natural 
resources  without  having  too  dense  a  population.  We 
are  productive  in  many  lines  of  agriculture,  particularly 
perhaps  in  the  raising  of  wheat,  corn,  and  cotton.  We  are 
also  productive  in  certain  lines  of  manufacture,  having, 
for  example,  in  Pennsylvania  and  in  Alabama,  great 
advantages  for  the  manufacture  of  steel  and  steel  prod- 
ucts. In  these  various  lines  of  effort,  the  United  States 
is  so  productive  that,  even  with  reasonably  low  prices 
received  for  the  goods,  the  daily  wages  of  labor  in  these 
lines  are  high  compared  with  European  standards.  Since 
we  are,  in  these  lines  of  activity,  so  productive,  those  in 
all  other  lines  of  industry  must  get  equally  high  wages  or 
they  will  go  into  these.  That  is,  assuming  open  compe- 
tition, the  national  prosperity  cannot  be  confined  to  any 
one  occupation.  Thus,  since  our  wheat  raisers  and  steel 
producers  are  prosperous,  our  bricklayers,  carpenters, 
plumbers,  etc.,  need  to  be  well  rewarded  to  keep  them  in 
their  work.  Therefore,  the  prices  of  houses  and  of  other 
goods  which  cannot  be  imported,  and  in  producing  which 
this  country  does  not  have  the  superiority  that  it  has  in 
cotton,  wheat,  steel,  etc.,  will  be  high. 

From  these  considerations  it  would  appear  that  if 
wheat,  cotton,  steel,  and  some  other  lines  of  industry  are, 
in  the  United  States,  exceptionally  productive,  it  is  the 


96     ECONOMIC  ADVANTAGES  OF  COMMERCE 

most  economical  policy  for  us  to  import  other  products 
which  we  can  obtain  more  cheaply  abroad,  rather  than  to 
employ  our  own  high-priced  labor  in  relatively  unpro- 
ductive effort.  The  prosperous  country  ought  to  have 
higher  money  wages,  but  not  higher  prices  of  importable 
commodities  except  as  transportation  and  distributing 
costs  make  them  higher.  The  fact  that  we  have  great 
natural  resources  in  comparison  to  population,  and  that 
our  labor  is  in  some  lines  very  productive,  should  make 
us  immensely  more  prosperous  than  the  older  and  more 
crowded  countries  whose  resources  in  comparison  with 
their  populations  are  much  less  than  ours,  and  should 
make  real  wages  markedly  higher  here.  For  decades 
we  have  had  a  tariff  policy  admirably  adapted  to  raise 
the  cost  of  living  and  decrease  our  prosperity.  If  we 
have  been  prosperous  and  if  our  wages  have  been  high, 
it  has  been  in  spite  of  and  not  because  of  the  tariff. 
Comparing  two  European  countries,  England  and  Ger- 
many, the  former  the  stock  example  of  free  trade,  the 
latter  a  protectionist  country,  we  find  prices  some  18 
per  cent  higher  in  Germany  and  money  wages  lower.1 

1  See  "A  Comparative  Study  of  Railway  Wages  and  the  Cost  of  Living  in 
the  United  States,  the  United  Kingdom,  and  the  Principal  Countries  of  Con- 
tinental Europe,"  Bureau  of  Railway  Economics,  Bulletin  No.  34,  Washington, 
D.C.,  1912,  pp.  ii,  35,  and  67.  In  the  same  Bulletin  (p.  n),  it  is  shown  that 
railway  wages  in  the  United  States  in  1900-1910  averaged  $2.23  per  day  as  com- 
pared with  wages  in  England  and  Wales  for  1910  of  $1.067.  It  is  also  shown 
(p.  67)  that  prices  in  the  United  States  for  goods  in  workmen's  budgets  in  1909 
were  38  per  cent  higher  than  in  England  and  Wales.  It  appears,  therefore, 
that  despite  the  tariff,  naturally  favoring  conditions  have  kept  American  real 
wages  somewhat  higher  than  English  wages,  but  not  so  much  higher  as  a  com- 
parison of  money  wages  alone  might  lead  us  to  suppose.  Comparative  railway 
wages  are  probably  as  good  an  index  of  comparative  wages  in  general  as  is 
available. 


PROTECTION  AND  DISTRIBUTION  97 

§4 

The  Eject  of  Protection  on  Wages  and  Rent  when  the 
Protected  Goods  are  Produced  under  Conditions  of 
Sharply  Increasing  Cost 

Still,  assuming  the  unprotected  product,  wheat,  to  be 
produced  in  Canada  at  so  nearly  constant  cost  that  the 
withdrawal  of  some  labor  into  linen  making  will  not 
appreciably  lower  the  price  of  wheat,  let  us  suppose  the 
conditions  to  be  such  that  linen  manufacturing,  in 
Canada,  can  be  extended  only  at  increasing  cost.  We 
may  suppose,  for  instance,  that  there  are  a  very  few  sites 
favorably  located  near  sources  of  cheap  power  and  on 
transportation  lines,  and  that  upon  these  sites  linen  can 
be  produced,  even  in  Canada,  for  $i  a  yard,  or,  at  worst, 
for  less  than  $1.43.  But  most  of  the  desired  supply,  in 
the  absence  of  protection,  is  obtained  from  Ireland, 
Protection,  by  shutting  out  the  supply  from  abroad, 
encourages  the  use  of  the  poorer  sites  in  Canada,  since 
the  better  sites,  by  our  hypothesis,  cannot  produce 
enough  to  satisfy  the  demand.  To  remunerate  pro- 
ducers on  the  poorer  sites,  the  price  must  be  higher,  say 
$1.43  a  yard.  If  it  is  not,  producers  on  the  poorer  sites 
cannot  pay  the  prevailing  rate  of  wages.  If  it  is,  pro- 
ducers on  the  better  sites  have  a  surplus  or  rent,  since 
production  costs  them,  in  wages,  less  money  per  yard 
than  it  costs  producers  on  the  poorer  sites. 

Otherwise  expressing  the  matter,  we  may  say  that  a 
week's  labor  in  Canada  will  produce  20  yards  of  linen 
on  the  better  sites,  but  only  14  on  the  poorer  sites.  If 
the  poorer  sites  are  to  be  used,  wages  cannot  be  more  than 
14  yards  a  week  or  the  money  equivalent  of  14  yards. 
But  the  owners  of  the  better  sites  have  a  surplus,  after 
PART  n  —  H 


98     ECONOMIC  ADVANTAGES  OF  COMMERCE 

paying  these  wages,  of  6  yards  or  the  money  equivalent 
of  6  yards. 

So  far,  then,  as  Canada  supplies  itself,  after  the  protec- 
tive policy  is  adopted,  with  Canadian  linen  manufactured 
on  the  most  favorable  sites,  there  is  no  national  loss. 
Wages,  that  is,  real  wages,  are  lower.  The  rents  of  the 
favorable  factory  sites  are  higher.  Money  wages  are  not 
lower,  but  linen  is  higher  in  price,  and  the  rise  goes  to 
increase  the  incomes  of  land  owners.  So  far  as  Canada 
supplies  itself  with  linen  from  the  less  advantageously 
located  factories,  the  higher  price  means  a  loss  to  wage 
earners  with  no  corresponding  gain  to  the  owners  of  land. 
Under  the  conditions  of  production  here  assumed  (pro- 
duction of  linen  under  conditions  of  increasing  cost  and 
of  wheat  at  nearly  constant  cost),  the  protective  tariff 
would  indeed  decrease  the  net  wealth  and  income  of  the 
protectionist  country,  but  the  land  owning  class  would 
gain.1  Rents  of  lands  required  for  the  protected  industry 
(assumed  to  be  of  increasing  cost)  would  rise  to  a  greater 
degree  than  rents  of  lands  required  for  unprotected  in- 
dustries (assumed  to  be,  within  limits,  of  nearly  constant 
cost)  would  fall.  The  total  national  loss  in  yearly  income 
would  therefore  be  less  than  the  loss  of  the  wage  earning 
class  alone.  Part  of  the  loss  of  the  wage  earning  class 
would  be  absolute  national  loss ;  the  rest  would  be  loss 
balanced  by  land  owners'  gain. 

No  essential  corrections  need  to  be  made  in  these  con- 
clusions because  of  the  inflow  of  money  resulting  from 

1 A  similar  result,  except  that  there  would  be  an  outflow  of  money  and  a  fall 
of  money  prices,  would  follow,  under  our  assumptions,  from  a  restrictive  export 
duty  on  wheat.  Such  a  duty  would  prevent  production  of  wheat  for  export, 
drive  some  Canadian  labor  into  other  lines,  e.g.  the  manufacture  of  linen,  even 
though  for  small  returns,  reduce  real  wages,  and  raise  the  rents  of  land  and  sites 
required  in  the  newly  expanded  lines  of  industry. 


PROTECTION  AND  DISTRIBUTION      »     99 

protection.  Under  the  assumed  conditions,  the  second- 
ary rise  of  prices  so  caused  would  affect  rents,  wages,  and 
nearly  all  prices,  alike. 

Duties  of  the  special  kind  here  criticised,  we  have  had 
in  plenty  in  our  own  various  protective  tariff  acts.  Our 
protective  tax  on  coal,  compelling  resort  to  the  poorest 
native  mines  in  preference  to  securing  some  coal  from 
abroad,  has  doubtless  tended  to  increase  the  value  of 
native  mines  and  the  profits  of  mine  owners,  but  has  done 
this  only  at  the  greater  expense  of  the  wage  earning  pub- 
lic. The  protection  accorded  to  raw  wool  by  the  much 
criticised  schedule  K  of  the  Payne-Aldrich  tariff  bill, 
certainly  tended  to  encourage  the  production  of  wool 
in  the  United  States  on  lands  which,  otherwise,  it  would 
not  have  paid  to  use  for  that  purpose.  The  owners  of 
lands  used  for  sheep  raising  were  doubtless  in  many  cases 
able  to  realize  larger  profits  or  higher  rents,  but  only  at 
the  greater  expense  of  others,  largely  the  wage  earners. 

In  estimating  the  relative  costs  of  production  of  raw 
wool  in  different  countries  and  in  different  parts  of  the 
United  States,  the  Tariff  Board  subtracted  the  receipts 
to  sheep  raisers  from  other  things  than  the  wool,  chiefly 
from  mutton.  There  was  left,  in  their  reckoning,  a  cost 
which  the  wool  must  cover.  This  surplus  cost  they  found 
to  be  nothing  in  New  Zealand  and  on  the  favorably  sit- 
uated runs  of  Australia,  a  very  few  cents  a  pound  for 
Australasia  in  general,  4  or  5  cents  a  pound  for  South 
America,  gj  cents  a  pound  for  the  United  States, 
ii  cents  for  the  "fine"  and  "fine  medium"  wools  of  the 
American  west,  and  19  cents  for  the  fine  wools  of  Ohio 
and  the  contiguous  territory.1  The  effect  of  protection 

i  Report  of  the  Tariff  Board  on  Schedule  K  of  the  Tariff  Law,  1912,  Vol.  I, 
Part  I,  pp.  10,  ii. 


ioo    ECONOMIC  ADVANTAGES  OF  COMMERCE 

(now,  fortunately,  removed  from  raw  wool)  has  been  to 
shut  out  very  largely  the  lower  priced  foreign  wool, 
to  compel  the  use  of  the  high-priced  American  wool,  to 
make  wool  production  profitable  on  lands  relatively 
unsuited  for  it,  to  make  the  rental  value  of  these  lands 
higher,  and  to  make  real  wages  lower.  In  the  opinion 
of  the  tariff  board,  the  highest  production  cost  in  the 
world,  of  the  merino  wools  largely  required  by  American 
mills,  is  in  the  state  of  Ohio  and  near-by  surrounding 
territory ; 1  yet  a  high  protective  tariff  on  raw  wool  so 
shut  off  the  supply  from  abroad  as  to  cause  large  produc- 
tion of  it  in  that  region.  That  the  general  effect  of  this 
protection  to  raw  wool,  accorded  by  the  Payne-Aldrich 
tariff  bill,  must  have  been  to  lower  wages  while  probably 
raising  the  rents  of  land  owners,  hardly  seems  open  to 
serious  question. 

§5 
The    Effect  of   Protection    on    Wages   and    Rent    when 

Unprotected  Goods  are  Produced  under  Conditions  of 

Sharply  Increasing  Cost 

We  may  now  consider  a  third  possibility  as  to  costs  of 
production,  viz.  that  the  protected  goods,  e.g.  linen,  are 
produced  under  conditions  of  nearly  constant  cost, 
while  the  unprotected  goods,  e.g.  wheat,  are  produced 
under  conditions  of  increasing  cost.  Under  these  cir- 
cumstances, not  much  labor  can  be  turned  into  linen 
manufacturing  without  lowering  the  marginal  labor  cost 
of  producing  wheat.  For  as  labor  is  diverted  from 
wheat  to  linen  production,  the  poorer  wheat  lands  are 
deserted,  and  on  the  better  lands  a  week's  labor  can 
produce  more  than  20  bushels.  If,  therefore,  Canada's 

1  Report  of  the  Tariff  Board  on  Schedule  K  of  the  Tariff  Law,  1912,  Vol.  I, 
Part  I,  pp.  10,  ii. 


PROTECTION  AND  DISTRIBUTION          101 

tariff  effectively  excludes  foreign  linen,  either  Canadian 
linen  will  sell  for  more  than  $1.43  a  yard  or  Canadian 
wheat  for  less  than  $i  a  bushel  or  both  such  changes  will 
occur.  Otherwise  no  one  will  desert  any  but  the  very 
worst  wheat  lands  in  order  to  produce  linen.  Competi- 
tion of  wheat  raisers  who  would  rather  sell  wheat  for  less 
than  $i  a  bushel  than  linen  for  only  $1.43  a  yard  will 
tend  to  keep  wheat  prices  down.  Reluctance  of  such 
persons  to  produce  linen  will  tend  to  keep  linen  prices  up. 
The  ratio  of  the  value  of  a  bushel  of  wheat  to  the  value  of 
a  yard  of  linen  must  lie  at  such  a  point  that  returns  to 
marginal  producers  (i.e.  producers  having  the  least  favor- 
able situations,  but  whose  goods  are  nevertheless  de- 
manded), shall  be  about  equal  in  both  lines.  Hence,  it 
will  take  more  than  20  bushels  of  wheat  to  equal  in  value 
14  yards  of  linen.  If  Canada  were  financially  isolated 
and  the  quantity  of  money  in  Canada  remained  un- 
changed, we  should  expect  that  the  changed  conditions 
of  cost  would  be  accompanied  by  both  a  rise  of  linen 
and  a  fall  of  wheat  prices.  Unless  there  was  an  increased 
quantity  of  currency  in  Canada,  a  rise  of  the  price  of  linen 
above  $1.43  a  yard  could  hardly  take  place  (other  things 
equal)  without  a  fall  in  the  price  of  wheat  below  $i ;  and 
unless  there  was  a  decreased  supply  of  currency,  wheat 
could  hardly  fall  below  $i  without  there  being  a  rise  in 
the  price  of  linen  above  $1.43. 

But  with  Canada  maintaining  a  gold  standard,  the 
common  standard  of  most  of  the  commercial  world,  and 
having  a  foreign  market  for  her  wheat,  the  price  of  the 
wheat  cannot  greatly  fall.  Any  tendency  of  the  price 
to  fall,  in  Canada,  would  be  counteracted  by  exportation 
and  sale  abroad  at  world  market  prices.  Any  change  in 
relative  values  will  be  through  a  rise  in  price  of  linen 


102    ECONOMIC  ADVANTAGES  OF  COMMERCE 

above  $1.43,  rather  than  through  a  fall  in  price  of  wheat 
below  $i.  Since  importations  of  goods  into  Canada 
are  interfered  with,  there  must  be  for  a  time  a  net  money 
inflow,  and  there  must  be  a  money  inflow  for  wheat  if 
and  so  long  as  it  sells  for  much  less  than  $i  a  bushel. 
This  inflow  of  money  into  Canada  tends  to  raise  average 
prices  in  the  proportion  of  the  money  inflow.  Were  the 
wheat  produced  under  conditions  of  approximately 
constant  cost,  the  inflow  of  money  must  necessarily  tend 
to  raise  its  price  in  the  same  proportion.  For,  since  it 
raises  prices  generally  in  that  proportion,  the  industry  of 
wheat  raising  must  yield  correspondingly  larger  money 
returns  or  it  would  be  less  profitable  than  others.  But 
under  conditions  of  increasing  cost,  the  circumstances  are 
different.  On  the  better  lands,  the  profits  of  wheat  rais- 
ing, even  with  the  higher  money  cost  of  production  and 
at  a  price  little  if  at  all  higher  than  before  the  tariff  was 
laid,  will  be  sufficient  to  keep  those  lands  under  cultiva- 
tion.1 Rather  than  turn  to  the  protected  industries,  such 
as  linen  manufacture,  until  Canada  only  produces  enough 
wheat  for  her  own  use  and  has  none  for  export,  and  until 
wheat  has  risen  in  price  in  the  same  ratio  that  money  has 
increased,  Canadian  farmers  on  the  better  lands  will 
prefer  to  remain  producers  of  wheat.  This  will  result 
in  a  supply  sufficient  to  keep  the  price  from  rising  very 
much  above  the  former  price.  In  fact,  if  we  assume 
wheat  production  to  be  the  line  of  industry  in  which 
Canada  is  relatively  the  most  efficient  and  wheat  to  be 
Canada's  chief  or  only  export,  we  must  conclude  that 
Canadian  wheat  cannot  rise  to  a  much  higher  price  than 
before,  despite  the  inflow  of  money.  For  wheat  can  be 
secured  in  large  quantities  from  many  other  sources  of 

1  Though  less  intensively  than  before. 


PROTECTION  AND  DISTRIBUTION          103 

production,  and  if  Canadian  wheat  rises  greatly  in  price, 
foreign  demand  for  Canadian  wheat  will  decrease, 
Canadian  producers  on  the  poorer  lands  will  give  up 
wheat  production,  and  Canadian  producers  on  the  better 
lands  will  accept  world  wheat  market  prices  rather  than 
abandon  wheat  production.  The  sale  abroad  of  Ca- 
nadian wheat  and  of  nothing  else  cannot,  by  causing  an 
inflow  of  gold,  raise  the  price  of  Canadian  wheat  very 
much  above  this  world  market  price,  since,  before  it  does 
so,  foreign  purchase  of  Canadian  wheat  will  cease,  the 
inflow  of  gold  will  cease,  and  the  rise  of  prices  will 
cease.1 

Assume  that,  as  a  result  of  protection,  Canadian  money 
increases  by  10  per  cent.  We  have  seen  that  average 
prices  will  tend  to  rise  by  10  per  cent,  in  addition  to  the 
original  43  per  cent  rise  of  the  protected  linen.  We  have 
seen  that,  under  our  supposed  conditions,  wheat  prices 
will  remain  substantially  unchanged.  Since  wheat  re- 
mains at  about  $i  a  bushel,  linen  will  rise  to  more  than 
$1.57  a  yard  and  wages  will  rise  to  more  than  $22  a 
week.2  It  follows  that  there  is  a  possibility  of  gain,  for 
wage  earners,  from  a  limited  application  of  protection ; 
though,  as  we  shall  see,  the  probability  of  this  gain  being 
realized  in  practice  is  remote.  So  far  as  they  are  con- 
sumers of  protected  goods,  wage  earners  lose  because 
of  the  rise  in  prices  of  these  goods,  occasioned  by  the 
tariff.  But  so  far  as  wage  earners  are  able  to  buy  at 
substantially  the  former  prices,  goods  produced  under 
conditions  of  increasing  cost,  while  having  money  wages 

1  Canadian  prices  cannot  rise  indefinitely  in  relation  to  foreign  prices  unless 
Canada  is  such  a  centre  of  gold  production  that  prices  rise  without  export  of 
goods  and  unless,  also,  all  imports  are  forbidden,  and  so  outflow  of  this  gold  is 
prevented. 

2  That  is,  by  more  than  10  per  cent  on  $  20. 


io4    ECONOMIC  ADVANTAGES  OF  COMMERCE 

greater  by  more  than  the  average  rise  of  prices,  with 
which  to  buy  these  goods,  they  are  gainers. 

On  the  other  hand,  owners  of  land  —  in  this  case, 
farming  land  —  are  losers.  And  they  lose  more  than 
wage  earners  gain.  Land  which  it  previously  paid  to 
cultivate  can  no  longer  be  cultivated  with  profit.  Land 
which  previously  yielded  a  large  surplus,  after  wages 
were  paid,  now  yields  a  smaller  surplus.  Since  the  wheat 
land  owners  (and  that  means,  in  large  part,  the  farmers), 
get  practically  no  higher  prices  for  their  wheat,  the  higher 
money  wages  which  they  have  to  pay  are  to  them  an 
unbalanced  loss.  So  are  the  higher  prices  they  must  pay 
for  protected  and  other  goods.  Their  loss  through  having 
to  pay  higher  wages  to  those  they  employ  is  not  cancelled 
for  the  nation  as  a  whole  by  a  corresponding  gain  to  their 
employees,  since  the  latter  have  to  pay  higher  prices  for 
linen.  Neither  are  the  higher  prices  which  farmers  and 
other  land  owners  must  pay  for  linen  balanced  by  the 
higher  money  wages  paid  to  linen  makers,  for  these 
wages  are  higher  only  by  virtue  of  the  secondary  rise 
resulting  from  the  inflow  of  gold  (the  original  43  cents 
rise  directly  due  to  the  tariff  merely  making  it  possible 
to  get  the  same  wages  in  linen  making  as  were  previously 
given  in  wheat  producing) ;  while  both  the  original  rise 
which  does  not  raise  wages  and  the  secondary  rise  which 
does,  must  be  borne  by  farmers  desiring  to  purchase 
linen.  It  seems  fair  to  conclude,  therefore,  that  if  wage 
earners  ever  do  gain  by  a  protective  tariff,  they  gain  at 
the  greater  expense  of  farmers  or  some  other  class. 
As  shown  in  the  previous  chapter,  average  wealth  is 
decreased. 

The  conclusion  that  a  protective  tariff  establishing  an 
industry  of  relatively  constant  cost,  and  decreasing  the  ex- 


PROTECTION  AND  DISTRIBUTION          105 

tent  of  an  industry  of  increasing  cost,  might  raise  wages 
at  the  expense  of  land  rent,  applies  equally  if  we  suppose 
the  protectionist  country  to  have  an  inconvertible  paper 
money  which  will  not  be  increased  by  an  inflow  of  gold. 
Suppose  Canada  to  have  such  a  currency.  Then,  as  we 
have. seen,1  the  original  rise  of  linen  to  $1.43  is  not  fol- 
lowed by  the  10  per  cent  further  rise  in  the  average  of 
prices.  But  the  value  relation  of  foreign  money  to 
Canadian  money  will  change,2  so  that  it  takes  more  for- 
eign money  than  before  to  buy  a  given  amount  of 
Canadian  money,  and  therefore  of  Canadian  goods.  To 
tempt  wheat  producers  away  from  any  but  the  worst 
lands  will  require  a  rise  of  linen  above  $1.43.  On  the 
other  hand,  the  price  of  wheat  will  fall  below  $i  a  bushel, 
since  it  can  be  produced  more  cheaply  on  the  better  lands 
and  since  the  greater  value  of  Canadian  money  compared 
to  foreign  money  will  prevent  the  export  of  any  wheat 
except  at  less  than  $i  a  bushel.  Money  wages  will  remain 
about  the  same,  $20  a  week.  Wheat  will  be  cheaper. 
Wage  earners  may  be  better  off,  but,  if  so,  only  at  the 
expense  of  even  greater  loss  to  agricultural  land  owners.3 
The  possible  gain  of  wage  earners  and  loss  to  agricul- 
tural land  owners  and  farmers,  can  perhaps  be  most 
clearly  shown  if  we  omit  reference  to  money  and  money 
prices.  When  the  Canadian  tariff  shuts  out  linen  from 
abroad,  the  value  of  linen,  in  Canada,  will  rise  in  terms 

1  Chapter  IV  (of  Part  II),  §  3. 

2  See,  for  example,  Part  I,  Ch.  VI,  §§  6,  7,  8,  9,  and  Part  II,  Ch.  IV,  §  3. 

3  A  restrictive  export  tax  on  wheat  might  have  a  like  result  on  the  relative 
interests  of  economic  classes,  though  having  an  opposite  result  on  the  general 
price  level.     Such  a  tax  would  cause  prices  to  fall  and  would  drive  industry 
from  wheat  raising  into  other  lines.     But  it  might,  conceivably,  by  preventing 
production  of  wheat  for  export  and  forcing  out  of  cultivation  the  poorer  lands, 
reduce  wheat  prices,  in  Canada,  more  than  it  reduced  prices  in  general  or  money 
wages. 


io6    ECONOMIC  ADVANTAGES  OF  COMMERCE 

of  wheat  until  it  becomes  profitable  for  men  to  leave  off 
cultivating  the  less  fertile  and  less  desirably  situated 
lands,  in  order  to  manufacture  linen.  Instead  of  20 
bushels  buying  20  yards,  as  before,  when  the  linen  was 
purchased  abroad,  20  bushels  will  buy  less  than  14  yards 
and  14  yards  will  buy  more  than  20  bushels.  For  if 
14  yards  of  linen  would  buy  but  20  bushels  of  wheat, 
only  those  on  the  very  worst  lands,  if  even  those,  would 
find  it  profitable  to  change  from  wheat  to  linen  produc- 
tion. If,  when  a  new  equilibrium  is  reached,  the  worst 
lands  still  cultivated,  and  the  marginal  labor  on  all 
wheat  lands,  yield  25  bushels  a  week  per  cultivator,1 
while  it  requires  a  week's  labor  to  make  14  yards  of 
linen,  then  25  bushels  will  exchange  for  14  yards.  Since 
considerable  labor  is  diverted  into  linen  manufacture  at 
a  wage  of  not  more  than  14  yards  (or  its  equivalent  in 
other  form),  a  week's  wages  in  wheat  production  will 
be  not  more  than  and  not  much  less  than  25  bushels  a 
week  (or  the  equivalent  in  other  form).  At  any  appre- 
ciably less  wage,  demand  for  labor  would  exceed  supply, 
because  at  any  less  wage  it  would  pay  to  hire  more  men, 
to  cultivate  land  more  intensively,  and  to  cultivate 
worse  land,  while  at  any  less  wage,  labor  could  not  so 
easily  be  kept  from  the  linen  factories  and  at  work  on 
the  farms.  Wages  in  terms  of  linen  are  less  (14  yards  in- 
stead of  20)  because  of  the  tariff.  Wages  in  terms  of 
wheat  are  greater  (25  bushels  instead  of  20)  because  of 
the  tariff.  If  the  wage  earner  has  occasion  to  consume 
much  wheat  and  to  use  little  linen,  his  real  wages,  in 
this  very  hypothetical  case,  will  be  higher.2  Owners  of 

1  That  is,  if  the  last  man  hired  adds  that  much  to  the  total  product.     See 
§  2  of  this  chapter  (V  of  Part  II). 

2  Cf.  Loria  in  the  Journal  of  the  Royal  Statistical  Society,  Vol.  L,  on  "Effects 
of  Import  Duties  in  New  and  Old  Countries,"  1887,  PP-  408-410;     Patten, 


PROTECTION  AND  DISTRIBUTION          107 

wheat  lands,  including  farmers,  will  lose  what  the 
wage  earners  they  hire  gain,  and  will  lose,  besides, 
from  the  higher  price  of  linen  in  terms  of  wheat.  The 
wheat-producing  wage  earners  will  not  gain  in  real  wages 
what  the  farmers  who  pay  them  lose,  for  it  will  take  more 
wheat  than  before  to  buy  14  yards  of  linen.  Neither 
will  the  linen-making  workmen  gain  as  much  from  the 
higher  price  of  linen  in  terms  of  wheat,  as  the  wheat 
producers  and  owners  of  wheat  lands  lose,  for  the  linen 
makers  gain  what  the  wheat  raisers  and  land  owners  lose, 
only  to  the  extent  that  they  trade  their  linen  wages  for 
wheat.  So  far  as  they  themselves  have  some  use  for 
linen,  they  also  lose. 

We  are  brought  back,  then,  by  another  route,  to  the 
conclusion  that  a  protective  tariff  will  only  add  to  the 
wealth  or  income  of  one  person  or  class  by  taking  a  larger 
amount  of  wealth  or  income  away  from  some  other 
person  or  class.1  It  is  conceivable,  though,  as  we  shall 

Economic  Basis  of  Protection,  Philadelphia  (J.  B.  Lippincott  Co.),  1895,  Ch. 
V ;  and  Bastable,  The  Theory  of  International  Trade,  fourth  edition,  London 
(Macmillan),  1003,  p.  105. 

1  A  number  of  economists  (e.g.  Sidgwick,  Edgeworth,  Carver)  have  appar- 
ently been  led  to  the  opinion  that  protection  might  not  only  raise  wages  but 
might  even  increase  the  total  national  wealth  by  drawing  labor  out  of  lines  of 
increasing  cost;  or  that  the  removal  of  protection  to  manufactures  and  other 
industries  of  relatively  constant  cost  might  decrease  national  productiveness  as 
well  as  reduce  wages.  Sidgwick,  for  instance,  imagined  a  protectionist  country 
of  limited  natural  resources  suddenly  becoming  a  free  trade  country,  and  its 
manufacturing  population,  previously  protected,  being  thereupon  undersold  by 
foreigners  and  driven  out  of  business  and  being  unable  to  obtain  employment 
in  agriculture  (The  Principles  of  Political  Economy,  London,  Macmillan,  1887, 
pp.  496-498).  But  if  agricultural  resources  were  in  such  a  country  so  limited 
as  to  give  little  or  no  employment  to  the  former  manufacturing  population, 
then  this  population  would  remain  chiefly  or  entirely  in  manufacturing,  accept- 
ing the  lower  wages  required  for  competition  with  the  imported  goods.  This, 
however,  could  not  possibly  decrease  the  national  wealth  (except  as  the  reduced 
wages  might  affect  efficiency)  for  the  land  owners  would  gain  as  much  as  the  wage 
earners  would  lose.  Employment,  at  some  level  of  wages,  would  continue,  and 
production  would  continue.  If,  with  removal  of  protection,  it  proved  possible 


io8    ECONOMIC  ADVANTAGES  OF  COMMERCE 

see,  far  from  probable,1  that  wage  earners  may  be  the 
gainers  and  land  owners  the  losers  by  such  a  policy. 

Let  no  one  welcome  this  conceivable  consequence  of  a 
carefully  devised  tariff  system,  on  the  ground  that  the 
situation  or  fertility  rent  secured  by  the  owners  of  supe- 
rior land,  is  unearned.  Assuming  that  it  is  unearned  (and 
it  is  no  part  of  the  function  of  this  book  to  discuss  at 
length  whether  or  not  land  rent  is  unearned),  a  change  in 
the  taxing  system  securing  to  the  public  its  full  rights 
to  any  such  unearned  wealth  or  income  would  be  more 
sensible  than  a  partial  loss  of  such  wealth  or  income 


to  employ  more  productively  in  agriculture  even  a  few  of  those  previously  en- 
gaged in  manufacturing,  the  total  national  wealth  would  be  increased  even  though 
wages  might  fall.  The  discussions  on  this  phase  of  protection  between  Profes- 
sors Bastable  and  Edgeworth,  in  the  Economic  Journal  (Vol.  X,  1900,  pp.  380- 
393  and  Vol.  XI,  1901,  pp.  226-229  and  582-590)  seem  to  the  present  writer 
not  to  bring  out  clearly  this  distinction  between  the  effect  on  national  wealth 
and  the  effect  on  wages.  (See  also  Bastable,  The  Theory  of  International  Trade, 
pp.  187-197-) 

Carver  (Publications  of  the  American  Economic  Association,  Third  Series, 
Vol.  Ill,  pp.  176-182)  uses  a  different  illustration  to  establish  what  seems  to 
be  the  same  conclusion  as  that  of  Sidgwick.  He  supposes  a  piece  of  land  which, 
in  the  absence  of  protection  or  some  form  of  legal  discrimination,  will  allow  the 
employment  of  one  man  in  sheep  raising,  while  it  might  otherwise  employ  20 
men  in  wheat  production.,  The  total  product,  he  assumes,  would  be  greater 
in  the  latter  case ;  but  the  land  owners'  rent,  if  trade  were  thus  interfered  with, 
would  be  lower.  Removal  of  restrictions  might  throw  19  men  out  of  work.  In 
criticism  of  this  view  it  is  to  be  said  that  there  are  two  extreme  possibilities. 
Either  the  19  men  have  a  preferable  alternative,  under  the  free  trade  regime,  to 
wheat  raising,  or  they  have  not.  If  they  have  not,  they  will  accept  low  enough 
wages,  rather  than  be  unemployed  and  have  nothing,  so  that  the  land  owner 
can  realize  as  much  rent  for  his  land  (or  more)  as  if  he  used  it  for  a  sheep  run. 
Unless  their  efficiency  is  thus  impaired,  they  will  then  produce  as  much  wheat 
as  if  they  were  protected.  The  effect  of  freedom  from  restriction  may  be  seen 
in  lower  wages  and  higher  rent,  but  not  in  decreased  national  wealth.  If,  how- 
ever, they  have  a  preferable  alternative,  these  19  men  will  not  raise  wheat  but 
will  occupy  themselves  otherwise  at  higher  wages  than  wheat  raising  under 
free  trade  would  yield  them,  while  the  land  owner  will  at  the  same  time  realize 
the  higher  rent  assumed  to  result  from  using  his  land  as  a  sheep  run.  Free 
trade  would  then,  also,  raise  rent  more  than  it  would  lower  wages. 
1  Shown  in  remainder  of  this  section  (5). 


PROTECTION  AND  DISTRIBUTION          109 

because  of  restrictions  on  trade.  At  any  rate,  those 
who  support  protection  with  the  argument  that  it  can 
be  made  to  benefit  wage  earners  at  the  expense  of  land 
rent,  should  be  the  last  to  oppose  direct  taxation  of  rent. 

In  practice,  the  likelihood  of  devising  a  tariff  which 
shall  benefit  wage  workers  at  the  expense  of  farmers  is 
extremely  small.  Such  a  tariff  must,  in  the  first  place, 
turn  enough  labor  from  agriculture  into  other  lines  to 
raise,  appreciably,  the  margin  of  cultivation.  That  is, 
so  much  of  the  poorer  land  previously  cultivated  must 
be  left  uncultivated,  that  the  poorest  land  remaining  in 
use  is  appreciably  better  than  the  poorest  land  which 
was  in  use.  Otherwise,  wages  in  terms  of  wheat  cannot 
be  appreciably  higher,  for  owners  of  the  poorer  lands 
cannot  pay  higher  wages,  and,  unless  labor  is  so  strongly 
drawn  into  other  lines  that  they  have  to,  owners  of  the 
better  lands  will  not.  To  have  any  appreciable  favorable 
effect  on  wages,  protection  must,  therefore,  set  up  large 
industries  or  many  industries,  giving  employment  to 
many  men. 

But  if  protection  is  to  be  of  benefit  to  wage  earners,  it 
must  be  levied  on  goods  consumed  not  at  all  or  only  to  a 
very  limited  extent  by  them,  and  on  no  other  goods,1 
so  that  any  rise  of  money  wages  which  may  take  place, 
shall  not  be  more  than  offset  by  higher  prices  of  goods 
workingmen  have  to  buy.2  The  problem  of  drawing  a 
large  amount  of  labor  away  from  agriculture  (usually 
regarded  as  an  industry  of  increasing  cost,  though  it  is 
by  no  means  always  an  industry  of  rapidly  increasing 

1  Or,  at  least,  only  slightly  on  other  goods. 

2  This  loss  to  wage  earners  is  borne  not  the  less  if  they  buy  goods  made  by 
machinery  which  has  been  raised  in  price  by  protection,  or  transportation  from 
railway  companies,  etc.,  which  have  to  charge  more  because  of  expensive  ma- 
terials. 


i  io    ECONOMIC  ADVANTAGES  OF  COMMERCE 

cost)  into  industries  (e.g.  many  kinds  of  manufacturing) 
of  relatively  constant  cost,  and  selecting,  as  industries 
into  which  to  draw  this  labor,  only  those  producing  goods 
little  used  by  the  masses,  is  indeed  a  problem  hard  to 
solve  and  a  problem  which,  in  the  exigencies  of  practical 
politics,  is  unlikely  ever  to  be  solved. 

As  a  matter  of  fact,  few  men  in  practical  politics  would 
dare  advocate  such  protection,  frankly  stating  its  in- 
tended result  and  how  the  result  was  to  be  attained ;  for 
most  men  in  politics  would  quickly  realize  that  such  an 
advocacy  would  be  likely  to  array  against  them  the  oppo- 
sition at  the  polls  of  nearly  all  the  farmers.  Our  own 
(United  States)  protective  tariff  has  been  levied  on  raw 
wool,  woolen  cloth,  cotton  cloth,  sugar,  fruit,  potatoes, 
shoes,  coal,  etc.  It  has  been  very  far  from  being  a  tariff 
which  would  raise  wages  at  the  greater  expense  of  rent. 
Rather  has  it  been  a  general  grab  in  which  as  many 
interests  as  possible  have  tried  to  get  something  at  the 
expense  of  the  general  interest.  It  requires  no  argument 
to  show  that  our  protection  has  not  been  designed  to 
avoid  the  things  that  the  masses  of  working  people  have 
to  consume.  Nor  has  it  by  any  means  avoided  goods 
produced  under  conditions  of  increasing  cost,  protection 
of  which  is  likely  to  raise  land  rents,  to  the  greater  loss 
of  wage  earners.  From  the  log  rolling  of  actual  political 
struggle,  there  is  likely  to  issue  a  hodge-podge  of  tariff 
rates,  causing  loss  to  nearly  all.  The  general  average 
of  American  wages  might  be  made  higher  by  shutting  out 
the  immigrant  laborers  who  enter  this  country  as  com- 
petitors of  those  already  here ;  but  the  average  American 
real  wages  are  distinctly  not  raised  by  shutting  out  and, 
therefore,  making  scarce  and  dear,  the  goods  which  wage 
workers  desire  to  consume. 


PROTECTION  AND  DISTRIBUTION          HI 

§6 

How  Protection  May  Benefit  One  Section  of  a  Country  at 
the  Expense  of  Other  Sections 

A  protective  tariff  may  benefit  absolutely  one  section 
of  a  country,  including  manufacturers,  wage  earners,  and 
farmers ;  but  if  so,  only  at  the  greater  expense  of  some 
other  section  or  sections.  Protection  to  manufacturers 
of  woolen  cloth,  in  certain  sections  of  New  England,  may 
benefit  people  in  those  sections,  who  are  unwilling  to 
move  elsewhere,  by  making  purchasers  of  cloth  in  other 
parts  of  the  United  States  pay  tribute  to  them.  It  may 
conceivably  even  work  a  benefit  to  farmers  and  farm 
land  owners  in  the  immediate  vicinity  of  the  protected 
mills,  since  the  protected  mill  owners  and  mill  workers, 
though  gaining  something  at  the  expense  of  the  rest  of  the 
nation,  would  have  to  share  these  gains  with  local  dairy- 
men and  truck  farmers  in  order  to  get  the  latters'  ser- 
vices, just  as  they  would  have  to  share  these  gains  with 
local  building  contractors,  bricklayers,  and  so  forth.1 
The  gain,  if  there  is  a  gain,  is  not  equivalent  to  the  loss 
of  other  sections,  for  the  people  of  the  locality  benefited 
have  the  option  of  seeking  better  opportunities  in  these 
other  sections,  even  if  they  do  not  care  to  carry  on  other 
industries  where  they  are.  If  other  sections  have  greater 
resources,  then  artificially  to  prevent  migration  into  them 
is  to  diminish  national  prosperity,  is  to  decrease  wealth 
production  in  the  naturally  favored  sections  more  than  it 
is  increased  in  the  less  favored.  And,  in  any  case,  to 
turn  industry  into  a  line  it  would  not  otherwise  follow, 
is,  presumably,  to  diminish  national  prosperity.  The 
policy,  when  all  sections  are  considered,  brings  a  net  loss. 

1  Cf.  Taussig,  Principles  of  Economics,  New  York  (Macmillan),  1911,  Vol.  £ 
p.  511. 


ii2    ECONOMIC  ADVANTAGES  OF  COMMERCE 

While  there  is  reasonable  ground  for  the  opinion  that  no 
large  section  of  the  United  States  has  really  gained 
by  the  long  continued  maintenance  of  protective  duties, 
or  could  gain  more  than  it  would  lose,  in  the  general 
compromise  of  protective  tariff  making,  yet  certain 
parts  of  the  country  have  felt  themselves  particularly 
injured.  This  has  been  the  feeling  in  most  of  the 
Southern  states,  and  is  one  explanation  for  the  phenom- 
enon of  a  "solid  South."  The  cotton-raising  states  have 
realized  that  their  staple  product  must  be  in  part  ex- 
ported, and  that  a  protective  tariff  could  not  appre- 
ciably, if  at  all,  raise  its  price.  And  they  have  known 
full  well  that  the  prices  of  many  things  they  have  had 
to  buy  have  been  very  considerably  raised  in  price  by  the 
tariff.  The  wheat-producing  areas  of  the  middle  West 
and,  doubtless,  certain  manufacturing  centres  of  the  East, 
have  been  in  a  similar  situation. 

It  is  probably  such  facts  as  these,  which  have  appar- 
ently produced  in  the  minds  of  some  of  our  public  men 
the  feeling  that  a  protective  tariff  is,  in  spirit,  unconsti- 
tutional, a  feeling  which  found  recent  expression  in  the 
National  Democratic  platform  of  1912.  The  Federal 
Constitution  has  given  to  Congress  and  the  President 
the  right  to  levy  import  duties  and  the  right  to  regulate 
commerce  with  foreign  nations.  The  passing  of  a 
protective  tariff  law  has  always  been  regarded  as  but  an 
exercise  of  these  powers.  There  is  little  reason  to  sup- 
pose that  any  Federal  court  would  set  aside  a  tariff  law  as 
unconstitutional  merely  because  it  was  protective.  A 
court  would  not  be  likely  to  go  behind  the  professed 
intent  of  Congress  and  the  letter  of  the  Constitution,  in 
order  to  raise  questions  regarding  the  ultimate  economic 
effects  of  the  laws  passed.  Such  questions  would  be 


PROTECTION  AND  DISTRIBUTION          113 

assumed  to  be  questions  for  the  legislature  and  not  the 
judiciary  to  decide.  Therefore,  Congress  and  the  Presi- 
dent must  themselves  decide  upon  the  constitutional 
justification  of  a  protective  tariff.  But  the  contention 
that  to  use  either  the  tax-levying  power  or  the  power  to 
regulate  commerce,  in  such  a  way  as  to  compel  the  people 
of  some  states  to  pay  tribute  to  producers  in  other  states, 
is  contrary  to  the  real  spirit  of  a  constitution  framed  as 
the  basis  for  a  federation  of  states,  is  a  contention  not 
without  a  degree  of  plausibility. 

§7 
Protection  as  an  Encouragement  to  Monopoly 

In  its  practical  results,  the  tariff  is  likely  to  operate 
in  taxing  the  entire  nation,  not  for  the  benefit  of  all  the 
people  in  any  one  section,  but  for  the  protection  of  mo- 
nopoly profits.  Though  a  tariff  schedule  may  not  be  at 
first  devised  for  this  purpose,  —  and  of  course  it  would 
not,  at  least  openly,  be  so  devised,  —  it  comes  to  have 
this  effect  if  it  encourages  combination.  This  the  tariff 
is  likely  to  do.  For  it  protects  producers  against  foreign 
competition  and  so  suggests  to  them  the  hope  that,  by 
combining  among  themselves,  they  may  realize  monopoly 
profits.  A  protective  tariff  which  has  only  this  effect 
cannot  be  said  to  benefit  the  masses  of  the  people  in  any 
section.  It  certainly  has  no  effect  on  real  wages  other 
than  to  lower  them,  if,  as  is  usually  the  case,  the  goods 
produced  are  goods  largely  consumed,  directly  or  in- 
directly, by  working  people.  For  the  only  way  the  tariff 
can  possibly  create  or  maintain  monopoly  profits,  is  to 
create  or  maintain  monopoly  prices ;  and  that  means  that 
it  takes  money  from  the  masses  of  the  people,  in  order  to 
give  it  to  monopolists. 

PART   II  —  I 


ii4    ECONOMIC  ADVANTAGES  OF  COMMERCE 

§8 

Summary 

We  have  now  to  summarize  the  conclusions  we  have 
reached  regarding  the  effect  of  protection  on  classes  and 
sections.  Because  protection  tends  to  diminish  national 
wealth,  it  has  a  tendency  to  restrict  the  extent  of  round- 
about production,  to  make  the  rate  of  interest  higher 
(though  not  necessarily  the  total  amount  of  interest), 
and  to  make  wages  lower.  This  is  an  indirect  effect. 
But  there  is  a  more  obvious  direct  action.  When 
both  protected  and  unprotected  goods  are  produced,  in 
the  protectionist  country,  under  conditions  of  approxi- 
mately constant  cost,  the  effect  of  protection  is  to  reduce 
real  wages^A  If  the  protectionist  country  and  those 
trading  with  it  have  a  common  monetary  standard,  then 
money  wages  in  the  former  will  rise  and  money  prices 
will  rise  in  the  same  proportion,  except  that  there  will  be 
a  special  rise  of  the  protected  goods,  in  addition,  so  that 
real  wages  will  be  lower.  Assuming  the  protected  in- 
dustry to  be  one  of  increasing  cost,  while  the  unprotected 
industries  are  of  relatively  constant  cost,  it  appears  that 
protection  may  benefit  land  owners  by  raising  land  rents, 
but  that  the  gain  of  land  owners  must  be  less  than  the  loss 
of  wage  earners. 

On  the  other  hand,  there  is  a  conceivable  case  in  which 
wage  earners  gain  at  the  greater  expense  of  land  owners, 
viz.  when  the  protected  goods  are  produced  under  con- 
ditions of  relatively  constant  cost  and  unprotected  goods 
under  conditions  of  increasing,  perhaps  sharply  increas- 
ing, cost,  and  when  wage  earners  are  chiefly  concerned, 
as  consumers,  with  unprotected  goods.  Given  these 
conditions,  real  wages  will  be  higher  because  of  protection, 


PROTECTION  AND  DISTRIBUTION  115 

and  the  rents  of  land  (in  our  illustration,  the  profits  of 
farmers)  will  be  lower.  But  the  owners  of  land  lose  more 
than  the  wage  earners  gain.  Assuming  the  usual  inter- 
national monetary  relations,  money  wages  will  rise; 
money  prices  of  protected  goods  will  rise  more ;  money 
prices  of  the  unprotected  goods  produced  under  condi- 
tions of  increasing  cost  will  rise  little  or  not  at  all. 

It  appeared,  however,  that  the  mere  devising  of  a 
tariff  to  have  this  result  would  be  difficult,  since  it  would 
be  almost  impossible  to  divert  much  labor  from  the  indus- 
try or  industries  of  increasing  cost  and  so  to  make  possible, 
in  that  industry  or  those  industries,  higher  wages,  without 
protecting  the  production  of  and  raising  the  prices  of, 
goods  largely  consumed  by  wage  workers.^The  practical 
difficulties  in  the  way  of  passing  such  a  tariff  act  ap- 
peared to  be  no  less  great.  The  conflict  of  various 
interests  is  not  likely  to,  and  presumably  never  did, 
result  in  a  tariff  act  which  would  raise  wages  at  the  ex- 
pense of  land  rent.  Even  supposing  such  an  act  to  be 
practically  possible,  and  assuming  that  most  or  all  of 
land  rent  is  an  unearned  income  belonging  properly  to 
the  whole  people,  we  must  conclude  that  direct  taxa- 
tion of  such  rent  would  secure  the  larger  general  welfare 
and  the  less  waste,  as  compared  with  the  indirect  and  very 
partial  appropriation  of  it  and  partial  waste  of  it,  in- 
volved in  the  protective  tariff  policy. 

Protection  can,  it  was  shown,  benefit  a  considerable 
territory  within  the  protected  group  at  the  greater 
expense  of  another  section  of  the  same  nation.  In  the 
United  States,  the  South  has  usually  felt  itself  to  be  a 
sufferer  by  the  policy.  Protection  may  also  build  up  and 
secure  against  foreign  competition,  monopolies,  and  so 
injure  the  general  public  for  the  benefit  of  a  compara- 
tively few. 


CHAPTER  VI 

A  CONSIDERATION  OF  SOME  SPECIAL  ARGUMENTS  FOR 
PROTECTION 


The  Argument  that  Protection  is  Desirable  Because  it 
Keeps  Money  in  the  Protected  Country 

ONE  of  the  cruder  popular  arguments  for  protection 
is  that  it  keeps  the  people  of  the  protectionist  country 
from  spending  their  money  in  foreign  countries,  and  so 
gets  and  keeps  more  money  in  circulation  at  home.  It 
is,  of  course,  true,  as  we  have  seen,1  that  the  effect  of 
a  protective  tariff  is  to  decrease  imports,  while  still,  for 
a  short  time,  not  bringing  about  a  corresponding  decrease 
of  exports,  and  that  there  is,  in  consequence,  somewhat 
more  money  in  a  protectionist  country  than  otherwise 
there  would  be.  But  it  is  also  true  that  the  net  inflow 
of  money  or  of  gold  is  not  perpetual,  that  it  soon  reaches 
a  limit.  It  is  further  to  be  emphasized  that  money  or 
gold  is  not  the  thing  for  the  securing  of  which  trade  is 
really  carried  on.  No  one,  other  than  a  miser,  wants 
money,  except  that  he  may  pay  it  out  again  for  other 
goods. 

The  argument  in  favor  of  getting  money  into  the 
country  and  keeping  it  there,  occasionally  takes  the  form 
of  a  comparison  between  a  business  man  and  a  nation. 
It  is  asserted  that  a  business  man  is  reckoned  prosperous 

1  Chapter  IV  (of  Part  II),  §  i. 
116 


SPECIAL  ARGUMENTS  FOR  PROTECTION     117 

in  proportion  as  he  takes  in  more  money  than  he  pays 
out,  in  proportion  as  he  sells  more  goods  than  he  buys ; 
that  a  nation's  prosperity  is  similarly  to  be  secured  by 
selling  for  money  more  than  it  buys  with  money;  and 
that,  therefore,  a  limitation  on  purchases  from  abroad 
is  desirable. 

The  validity  of  such  a  comparison  is  sometimes  ques- 
tioned by  free  traders.  It  is  said  that,  since  a  nation 
is  not  the  same  as  a  single  individual,  what  conduces  to 
the  prosperity  of  the  latter  may  not  further  the  prosper- 
ity of  the  former.  But  free  traders  have,  as  such,  no 
occasion  to  question  the  validity  of  the  comparison, 
since  the  comparison  does  not  show  what  protectionists 
intend  it  to  show.  The  fact  is  that  a  successful  busi- 
ness man  does  not  take  in  more  money  than  he  pays  out. 
On  the  contrary,  he  is  always  anxious  to  expend  his 
money  (or  his  bank  deposit)  for  goods.  If  he  does  not 
spend  it  for  enjoyments,  he  will  wish  to  expend  it  by 
making  investments.  He  will  buy  automobiles,  yachts, 
residences,  theatre  tickets ;  or  he  will  purchase  factories, 
office  buildings,  railroad  shares,  machinery.  It  is  by 
the  one  type  of  purchases  that  he  endeavors  to  enjoy  his 
prosperity,  and  by  the  other  kind  of  purchases  that  he 
hopes  to  add  to  his  prosperity.  A  wealthy  man  is  not 
necessarily  one  who  has  a  large  amount  of  money  in  his 
pockets  or  one  who  has  a  large  checking  account.  More 
usually  his  assets  of  that  sort  are  small  compared  with 
his  property  in  railroads,  mills,  stores,  farms,  etc.  With 
a  nation,  which  is  a  collection  of  individuals,  the  aim 
should  be  similar.  A  nation  enjoys  its  prosperity,  in 
proportion  as  it  secures  many  services  and  many  goods 
for  immediate  consumption.  It  increases  its  prosperity 
in  proportion  as  it  secures,  from  abroad  if  it  can  get  more 


n8    ECONOMIC  ADVANTAGES  OF  COMMERCE 

by  purchasing  abroad,  large  capital  equipment  for  aid 
in  further  production.  For  a  nation  as  for  an  individ- 
ual, money  is  not  the  thing  most  to  be  desired,  but  the 
wealth  which  money  buys.  A  country  which  has  a 
large  amount  of  money  and  high  prices,  benefits  from  that 
fact  only  if  it  can  use  this  money  to  buy  goods  where 
prices  are  lower.  There  is  no  gain,  but  only  loss,  in 
preventing  purchase  abroad  in  order  to  get  and  keep 
money  within  a  protectionist  nation. 

§2 

The  Wages  Argument  for  Protection 

The  argument  for  protection,  which  has,  perhaps,  been 
most  persistently  urged  in  political  campaigns  within 
the  United  States  during  the  last  half  century  or  more, 
is  the  wages  argument.  We  have  already  discussed  at 
some  length  the  effect  of  protection  on  wages,1  and  need 
not  expand  greatly  upon  the  subject,  here. 

The  general  tendency  of  protection  is  to  divert  industry 
out  of  its  most  profitable  into  less  profitable  channels ; 
and  it  is  hardly  likely  that,  by  so  doing,  protection  will 
make  wages  higher.  We  may  rather  expect  that  it  will 
make  wages  lower.  In  fact,  as  we  have  seen,2  a  protec- 
tive tariff  cannot  directly3  raise  any  wages  without 
raising,  in  the  same  degree,  the  prices  of  protected  goods. 
And  further,  as  we  have  also  seen,4  to  the  extent  that 
protection  operates  to  turn  men  into  less  productive 
lines,  those  whose  wages  are  nominally  raised  will  not 

1  See  Ch.  V  (of  Part  II). 

2  Chapter  IV  (of  Part  H),  §  2. 

3  The  improbability  of  a  tariff's  raising  wages  indirectly  has  been  sufficiently 
discussed  in  Ch.  V  (of  Part  II),  §  5. 

4  Chapter  IV  (of  Part  II),  §  2. 


SPECIAL  ARGUMENTS  FOR  PROTECTION    119 

gain  (if  they  do  gain)  as  much  as  others  lose.  Even  if 
they  secure,  in  the  protected  industry,  wages  as  much 
higher  than  they  could  otherwise  get  in  that  line  as  their 
employers  get  higher  prices  for  the  protected  goods, 
they  will  not  be  getting  wages  correspondingly  higher 
than  they  could  have  secured  in  the  natural  and  relatively 
more  productive  industries  of  their  country.  The  pre- 
sumption is,  that  not  only  average  real  wages,  but 
even  the  real  wages  of  those  employed  in  protected 
industries,  will  be  lowered  by  protection.  For  compe- 
tition, so  far  as  it  is  free,  tends  to  equalize  condi- 
tions; and  no  one  trade  of  wage  earners  can  there- 
fore hope  to  gain,  for  any  long  period,  by  means  of 
protection,  even  at  the  greater  expense  of  wage 
earners  in  other  trades.  Rather  will  all  probably 
share,  ultimately,  in  the  national  loss.  Though  wages 
measured  in  money  may  be  slightly  higher  under  pro- 
tection because  of  an  inflow  of  gold,  wages  measured 
in  the"  necessaries,  comforts,  and  luxuries  of  life,  are 
practically  certain  to  be  lower. 

The  emphasis,  in  the  wages  argument  for  protection, 
is  sometimes  placed  on  the  alleged  danger  of  allowing 
American  workingmen  to  be  subject  to  the  competition 
of  cheap  foreign  labor,  the  competition  of  the  so-called 
"pauper  labor "  of  Europe.  The  truth  is  that  the 
" competition"  of  cheap  foreign  labor  cannot  do  other- 
wise than  benefit  the  country  as  a  whole.  Such  labor, 
e.g.  labor  engaged  in  the  production  of  woolen  cloth,  can 
only  injure  American  workingmen  employed  in  that 
industry,  by  benefiting  Americans  in  all  other  lines 
through  lower  prices  of  woolen  cloth.  And  the  Ameri- 
cans engaged  in  manufacturing  woolen  cloth  would  share 
in  this  benefit  when  they  had  turned  their  efforts  into 


120    ECONOMIC  ADVANTAGES  OF  COMMERCE 

other  lines  in  which  their  relative  efficiency  was 
greater.  If  it  is  really  so  dangerous  to  American  wage 
workers'  prosperity  to  have  goods  from  abroad  sold 
in  the  United  States  at  a  low  price,  and  the  more 
dangerous  the  lower  the  price,  then,  obviously,  it 
must  be  the  most  dangerous  of  all  if  the  goods  are 
given  to  us  for  nothing.1  What  ruin  to  our  in- 
dustries, what  poverty  and  suffering  must  be  caused, 
by  our  getting  quantities  of  goods  from  abroad  with- 
out having  to  produce  any  goods  to  send  in  return ! 
For  if  we  thus  secure  goods  from  other  countries  for 
nothing,  we  are  able  to  devote  all  our  energies  to  in- 
creasing still  further  our  stock  of  wealth  and  our  flow 
of  income  services. 

Frequently  an  inductive  wages  argument  is  attempted, 
based  on  a  comparison  between  the  United  States  and 
England.  Attention  is  called  to  the  fact  that  wages  in 
England  are  lower  than  wages  in  the  United  States,  and 
it  is  implied,  if  not  asserted,  that  the  difference  is  due 
to  the  British  policy  of  free  trade  as  contrasted  with 
an  historic  American  policy  (now,  however,  possibly  in 
process  of  abandonment)  of  protection.  Yet  every  one 
who  is  familiar  with  and  able  to  distinguish  between  the 
legitimate  and  the  illegitimate  processes  of  reasoning, 
knows  that  such  a  comparison  has  little  or  no  value 
unless  other  things  are  equal,  or  unless  the  effects  of  the 
other  things  which  are  not  equal  are  known,  and  can  be 
subtracted  from  the  total  result.2  As  a  matter  of  fact, 
other  things  are  not,  in  this  comparison  between  England 
and  the  United  States,  at  all  equal.  England  is  much 

1  An  effective  turn  to  the  argument  given  by  Henry  George  in  his  very  read- 
able Protection  and  Free  Trade,  New  York  (Henry  George),  1891,  pp.  121-125. 
J  See  Mm,  System  of  Logic,  Book  HI,  Ch.  VHI,  §  5  on  the  method  of  residues. 


SPECIAL  ARGUMENTS  FOR  PROTECTION    121 

more  crowded  than  the  United  States,  and  its  resources, 
in  comparison  to  population,  are  less.  With  thirty- 
three  millions  of  people  struggling  to  make  a  living  in  a 
country  about  the  size  of  the  state  of  Illinois  (which  has 
a  population  of  something  like  two  millions),  England 
can  hardly  be  expected  to  be  a  country  of  as  high  wages 
as  the  United  States.  Because  of  the  law  of  diminishing 
returns,  wages  in  England  must  be  comparatively  low 
in  order  that  the  demand  for  labor  shall  equal  the  supply. 
It  is  true  that  the  people  of  England  are  not  confined  to, 
and  are  not  mainly  occupied  in,  agriculture.  England 
is  primarily  a  manufacturing  and  commercial  nation. 
But  the  point  is,  that  England  has  to  engage  in  indus- 
tries employing  many  persons  per  unit  space,  in  order 
to  support,  comfortably,  so  large  a  population  in  so  small 
an  area.  Hence,  England  has  to  engage  in  commerce 
and  manufacturing,  even  if  competition  with  other 
crowded  countries  and  parts  of  countries,  reduces  the 
profits  and  wages  which  can  be  earned  to  a  comparatively 
low  level,  and  even  though  far  distant  markets  must 
be  sought  and  raw  materials  imported,  at  considerable 
expense,  from  abroad.  In  a  country  like  the  United 
States,  however,  there  is  always  the  alternative  of  going 
into  agriculture,  or  mining,  or  manufacturing  for  which 
resources  are  available  near  at  hand,  and  hence  wages 
tend  to  remain  at  a  higher  level.  Wages  in  the  United 
States  have  been  high,  not  because  of  a  protective 
tariff  which  has  tended  to  lower  them,  but  because  of 
the  favorable  relation  of  population  to  natural  resources. 
Wages  in  the  United  States  are  in  danger  of  being  low- 
ered, not  by  free  trade,  which  would  tend  to  raise  them, 
but  by  immigration  from  the  crowded  and  low- wage 
countries,  by  immigration  which  increases  the  supply 


122    ECONOMIC  ADVANTAGES  OF  COMMERCE 

of  labor,  lowers  the  margin  of  cultivation  toward  foreign 
levels,  and  makes  necessary  low  wages  to  equalize  supply 
of  and  demand  for  wage  earners'  services.1 

§3 

The  Make-Work  Argument  for  Protection 

Closely  associated  with  the  wages  argument  is  the 
argument  that  protection  makes  employment.  It  is 
said  that  the  tariff,  by  shutting  out  various  foreign  goods, 
gives  encouragement  to  American  capital  and  labor  to 
engage  in  producing  such  goods.  If  protection  does  this, 
it  is  only  because  protection  makes  the  production  of 
such  goods  more  profitable.  For  even  without  the  de- 
fence of  the  tariff,  home  producers  in  any  industry  could 
have  the  entire  home  market  and  could,  therefore,  sell 
all  the  goods  which  that  market  would  take  —  as  well 
as  some  goods  abroad  —  if  they  would  make  low  enough 
prices,  if  employers  and  employees  together  would  be 
willing  to  carry  on  the  business  without  aid,  and  take 
what  it  could  earn.  The  tariff  simply  enables  them  to 
do  a  business  no  larger,  at  higher  prices,  and  therefore 
at  the  expense  of  persons  in  other  industries.  If  em- 
ployment is  increased  in  one  industry,  it  is  only  because 
that  industry  is  made  more  profitable  than  it  otherwise 
would  be  and  because  men  will  choose  the  employment 

1  If  immigrant  wage  earners  always  went  into  the  lowest  grade  labor,  and 
if  they  and  their  descendants  remained  in  this  labor  only,  their  competition  might 
not  lower  wages  in  other  work.  If  it  increased  the  demand  for  other  work  more 
than,  by  pushing  former  low  grade  labor  into  such  work,  it  increased  the  supply, 
wages  in  this  other  work  might  rise.  Conceivably,  most  "native  labor  would 
find  employment  in  this  high  grade  work  (Hadley,  Economics,  New  York 
—  Putnam — ,  1906,  pp.  420-421).  But  in  a  few  generations,  the  descendants  of 
immigrants  are  competing  for  the  higher  positions  as  well  as  the  lower,  and, 
indeed,  it  would  be  more  difficult  to  realize  democratic  ideals  if  they  were  not. 
The  net  result  is  likely  to  be  a  reduction  of  wages  for  most  kinds  of  labor. 


SPECIAL  ARGUMENTS  FOR  PROTECTION     123 

that  pays  best.  Employment  is  made  less  profitable  in 
other  industries  than  it  would  else  be,  since  those  em- 
ployed in  these  industries  must  bear  the  tariff  burden. 
Will  not  the  protective  tariff,  therefore,  decrease  employ- 
ment in  these  other  industries  as  much  as  it  increases 
employment  in  the  favored  industry  or  industries  ? 

Another  way  to  look  at  this  matter  of  employment 
is  from  the  viewpoint  of  the  tariff's  effect  on  foreign 
trade.  In  a  previous  chapter l  it  was  pointed  out  that 
any  serious  restriction  of  imports  brings,  eventually,  a 
corresponding  limitation  on  exports.  It  follows  that 
to  give  employment  in  a  new  industry  started  by  a  pro- 
tective tariff,  is  to  take  away  employment  in  production 
of  goods  for  export. 

Even  if  the  people  of  foreign  countries  would  give  us 
our  imports  for  nothing,  —  which  they  will  not,  —  so 
that  our  labor  would  not  need  to  be  employed  in  produc- 
ing goods  to  return  to  them,  still  our  labor  might  be 
sufficiently  employed  in  producing  additional  goods  or 
in  producing  goods  of  a  different  kind  which  we  could 
not  secure  by  gift.  A  high  protective  tariff  would  shut 
out  the  free  goods  and  compel  our  labor  to  be  wasted  in 
producing  these  goods  at  home ;  but  it  would  not  make 
employment  greater  or  more  steady.  Our  labor  would 
simply  be  producing  goods  which  might  have  been  got 
for  nothing,  instead  of  getting  such  goods  free  and  pro- 
ducing additional  goods. 

Labor  can  be  employed,  and  at  high  wages,  when 
there  are  fertile  lands  or  good  sites  to  work  upon,  tools 
to  use,  available  wealth  to  pay  and  support  labor  during 
the  process  of  production  (if  roundabout),  and  a  prospect 
of  a  return  sufficient  to  compensate  for  the  outlay.  A 

1  Chapter  IV  (of  Part  II),  §  i. 


124    ECONOMIC  ADVANTAGES  OF  COMMERCE 

protective  tariff  does  not  increase  or  improve  the  lands 
or  the  sites ;  it  does  not  multiply  tools  or  increase  wealth, 
but  tends  rather  towards  national  poverty ;  it  does  not, 
for  industry  as  a  whole,  improve  the  prospects  for  large 
returns,  but  has,  rather,  the  reverse  effect.1  How,  then, 
can  a  protective  tariff  increase  employment? 

§4 

The  Home  Market  Argument  for  Protection 

In  political  struggle,  it  is  usually  fatal  to  antagonize 
any  very  large  class.  So  in  order  to  carry  through  a 
protective  policy,  it  has  been  necessary,  in  the  United 
States,  to  convince  not  only  wage  workers,  but  farmers  as 
well,  that  the  policy  would  benefit  them.  While  many 
products  of  the  farms,  e.g.  raw  wool,  have  been  protected, 
yet  it  has  been  difficult  to  show  that  the  great  agricul- 
tural staples,  such  as  wheat,  corn,  and  cotton,  have  been 
appreciably  raised  in  price  by  the  tariff  2  or  that  the  tariff 
could  directly  raise  their  prices.  The  appeal  to  American 
farmers  has  therefore  taken  the  form,  in  part,  of  assert- 
ing an  indirect  benefit  of  protection,  through  the  estab- 
lishment of  a  "home  market."  The  "home  market 
argument"  points  out,  to  begin  with,  that  a  protective 
tariff  increases  the  number  of  persons  engaged  in  the 
protected  industries,  e.g.  manufacturing.  Those  thus 

1  The  Arguments  of  Schiitter  (Schutzzoll  und  Freihandel,  Vienna— Tempsky  — , 
and  Leipzig  —  Freytag — ,1905,  pp.  75-84)  to  the  effect  that  industry  in  any 
country   is   not   rigidly   limited  by  the  factors  of  production,  but  may  vary 
within  wide  limits  in  relation  to  these  factors,  proves  nothing  whatever  for  pro- 
tection, unless  it  is  also  shown  that  industry  is  likely  to  fall  short  of  its  maximum, 
under  free  trade,  and  more  nearly  to  approximate  its  maximum,  under  protec- 
tion.   For  such  a  contention  (aside  from  possible  transitional  effects  during 
adjustment  to  a  changed  policy),  there  seems,  to  the  present  writer,  no  reason- 
able justification  either  in  theory  or  in  direct  experience. 

2  See  Ch.  V  (of  Part  II),  §  5. 


SPECIAL  ARGUMENTS  FOR  PROTECTION     125 

led  to  engage  in  manufacturing  then  have  to  buy  the 
products  of  the  farms,  and  so  the  farmers  secure  a  home 
market  for  these  products. 

The  answer  to  such  an  argument  has  already  been 
indicated  in  our  discussion  of  the  effects  of  a  protective 
tariff  on  exports.1  If  we  of  the  United  States  refuse  to 
buy  goods  from  abroad,  and  so  develop  the  production 
of  those  goods  at  home,  to  just  that  extent,  in  the  long 
run,  will  we  be  deprived  of  an  opportunity  to  produce 
goods  profitably  for  export.  The  farmers  can  only  gain 
a  home  market  by  losing  a  foreign  market.  And  the  extra 
prices  they  have  to  pay  for  goods,  especially  protected 
goods,  because  of  the  tariff,  will  cause  them  to  suffer  a 
net  loss. 

Sometimes  the  argument  in  favor  of  the  development  of 
a  home  market  takes  a  slightly  different  form.  Instead 
of  its  being  asserted  that  the  protected  manufacturing 
industries  will  not  exist  or  will  not  be  so  widely  ex- 
tended without  a  tariff,  emphasis  is  placed  on  the  conten- 
tion that  they  will  not  be  so  prosperous.  Those  engaged 
in  them  will  earn  less.  If  the  manufacturing  industries 
are  protected,  it  is  urged,  the  farmers  may,  indeed,  have 
to  pay  more  for  manufactured  goods ;  but  those  engaged 
in  manufacturing  will  then  have  more  money  with  which 
to  purchase  the  farmers'  products,  and  so  the  farmers 
will  get  their  money  back  again.  The  truth  is  that  they 
will  not  and  do  not  get  it  back  again  unless  they  give 
something  else  of  value  in  return.  If  a  farmer  pays  more 
for  clothes,  because  of  a  protective  tariff,  than  he  other- 
wise would,  we  may  admit  that  the  clothes  makers  will 
have  more  money  (other  things  equal)  with  which  to 
buy,  if  they  choose  to,  the  farmer's  products;  but  the 

i  Chapter  IV  (of  Part  II),  §  i. 


126    ECONOMIC  ADVANTAGES  OF  COMMERCE 

farmer  does  not  get  back  this  extra  money  for  nothing ; 
he  must  give  extra  products  for  it.  To  assume  that  the 
farmer  does  not  have  to  give  extra  products  to  get  back 
the  additional  money  paid  for  the  higher  priced  clothes, 
is  to  assume  that  the  protected  industry  is  not  encour- 
aged by  the  higher  prices  the  farmer  pays  for  its  goods ; 
for  this  is  to  assume  that  the  higher  prices  so  paid  by  the 
farmer  for  the  protected  goods,  are  balanced  by  higher 
prices  which  those  in  the  protected  industry  must  pay 
for  the  farmer's  products.  This  would  mean  no  change 
in  the  relative  positions  of  farmer  and  manufacturers 
because  of  protection,  save  a  merely  nominal  change. 
The  idea  which  protectionists  who  use  this  "get  it  back 
again"  argument  endeavor  to  convey  is  that,  somehow, 
producers  of  protected  goods  get  larger  real  incomes 
because  of  the  tariff;  while,  at  the  same  time,  those 
whose  purchases  of  goods  at  higher  prices  make  these 
larger  incomes  possible,  lose  nothing  by  the  system. 

The  absurdity  of  such  an  argument  is  perhaps  best 
shown  by  an  illustration.  Suppose  that,  in  a  small  town, 
there  are  a  number  of  robberies,  as  a  result  of  which  each 
of  the  merchants  of  the  town  finds  himself  minus  several 
hundreds  of  dollars.  Finally,  the  thief  is  apprehended. 
But  upon  being  accused  of  his  crimes,  he  asserts  in  his 
own  defence  that  he  has  really  done  no  harm.  Though 
he  admits  having  robbed  the  various  merchants  of 
money,  yet  he  points  out  that  he  has  lived  in  the  town 
and  has  used  all  of  this  money  to  buy  their  goods  and 
that  thus  they  have  "got  it  back  again."  The  obvious 
fact  is,  of  course,  that  the  merchants  have  only  got  their 
money  back  by  giving  up  for  it  other  goods  of  supposedly 
equal  value.1 

1  Cf.  Sumner,  Protectionism,  New  York  (Holt),  1885,  p.  125. 


SPECIAL  ARGUMENTS  FOR  PROTECTION     127 

Protection  may,  as  we  have  seen,1  benefit  one  section 
of  a  country  at  the  expense  of  other  sections ;  and  the 
gains  to  the  section  benefited  will  perhaps  be  distributed 
among  all  classes.  If  the  West  and  the  South  are  taxed 
to  develop  manufacturing  in  Rhode  Island,  the  Rhode 
Island  truck  farmers  and  dairymen  may  share  in  the 
local  gains  by  virtue  of  having  a  home  market  provided 
for  them  at  the  expense  of  others.  But  to  say  this  is 
very  different  from  saying  that  they  would  gain  if  the 
local  market  were  provided  entirely  at  their  own  expense. 

§5 

The  Argument  for  Protection  to  Agriculture  in  the  Older 
Countries  against  a  Future  when  Cheap  Foods  and 
Raw  Material  may  not  be  Obtainable  from  the  Newer 
Countries 

An  argument  not  generally  familiar  to  Americans, 
has  been  used  in  favor  of  protection  to  the  agriculture 
of  the  more  crowded  European  countries,  in  particular 
the  agriculture  of  Germany.2  There  is,  it  is  claimed, 
too  great  a  reliance  of  the  older  and  more  densely  settled 
countries  upon  the  new  countries  for  food  supplies  and 
raw  materials.  Eventually  the  new  countries  will  be 
more  thickly  settled,  will,  like  the  old,  devote  themselves 
in  larger  part  to  manufacturing,  and  will  have  smaller 
surpluses  of  food,  etc.,  for  export.  Therefore,  the  old 
and  thickly  settled  countries,  which  will  probably  have 
grown  still  more  in  population  during  the  period  of 
importing  food  and  raw  materials  from  abroad,  will  get 

1  Chapter  V  (of  Part  II),  §  6. 

2  See  Adolph  Wagner,  Agrar-  und  Industriestaat,  Jena  (Gustav  Fischer),  1901, 
p.  73.     A  good  statement  of  the  argument  is  given  in  Taussig,  Principles  of 
Economics,  New  York  (Macmillan),  1911,  Vol.  I,  pp.  534,  535. 


128    ECONOMIC  ADVANTAGES  OF  COMMERCE 

their  food  supplies  and  raw  material  with  increasing  diffi- 
culty. The  suggested  remedy  is  that  the  thickly  settled 
countries  should  levy,  each,  a  protective  tariff  on  such 
imports,  force  its  people  to  get  along,  in  the  main,  with 
what  can  be  produced  in  their  own  country,  resist  thus 
the  tendency  to  specialize  in  manufacture,  and  so 
prevent  the  growth  of  a  population  which  is  dependent 
upon  foreign  surpluses  for  its  food  and  necessary  mate- 
rials. 

If  the  fear  is  that  the  new  countries,  when  they  come 
to  develop  manufactures,  will  almost  without  exception 
shut  out,  by  protective  tariffs,  goods  manufactured  in 
the  older  countries,  and  so  eventually  compel  the  latter 
to  be  self-sufficient,  there  is  reason  in  the  suggestion  that 
these  older  countries  remain  self-sufficient  from  the 
beginning.  By  so  doing,  they  will  avoid  the  intense 
suffering  which  must  result  from  a  return  to  a  sparseness 
of  population  capable  of  securing  sufficient  food,  etc., 
at  home. 

But  if  the  world  can  be  expected  to  attain  a  liberal 
attitude  towards  trade,  if  a  tendency  towards  low  tariffs 
can  be  hoped  for  (and  this  is  perhaps  more  likely  to  be 
the  case  as  the  stage  of  infant  industry  is  left  behind), 
then  the  argument  for  protection  of  agriculture  has  very 
little  force.  For  no  matter  how  extensively  the  now 
sparsely  settled  countries  eventually  go  into  manufac- 
turing, they  will  not  go  into  it,  if  not  artificially  encour- 
aged, unless  it  yields,  on  the  average,  as  satisfactory 
returns  as  agriculture.1  That  manufacturing  popula- 
tions in  the  older  countries  will  have  to  meet  the  compe- 
tition of  manufacturing  groups  in  the  newer,  is  true. 
But  assuming  free  trade  (and  if  trade  is  not  free,  then  in 

1  On  the  margin  of  production. 


SPECIAL  ARGUMENTS  FOR  PROTECTION     129 

proportion  as  restrictions  are  slight),  this  merely  means 
that  the  manufacturing  populations  of  the  older  countries, 
cannot  charge  higher  prices  and  therefore  cannot  get 
higher  wages  and  profits  per  unit  product,  than  the  manu- 
facturing groups  in  the  newer  countries.  It  does  not 
mean  that  the  condition  of  the  old  countries  must  be- 
come appreciably  worse  than  that  of  the  new.  So  long 
as  many  persons  in  the  new  countries  care  to  engage  in 
manufacturing  (and  that  they  will  do  so  is  all  that  is 
feared),  it  must  be  that  manufacturing  is  about  as  profit- 
able as  agriculture.  If  it  were  much  less  so,  assuming 
free  trade  or  any  near  approximation  to  free  trade,  the 
newer  countries  would  withdraw  from  manufacturing  and 
the  older  countries  could  carry  it  on  without  competi- 
tion. If  manufacturing  in  the  new  countries  is  as  prof- 
itable as  agriculture,  and  if  trade  is  free,  manufacturing 
in  the  older  countries  (assuming  equal  efficiency)  must 
also  be,  except  for  the  greater  costs  of  transporta- 
tion, as  profitable  as  agriculture  in  the  new,  because  as 
profitable,  save  for  transportation  costs,  as  manufactures 
in  the  new. 

§6 

The  Infant  Industry  Argument  for  Protection 

The  argument  which  is  usually  regarded  by  economists 
as  stating  the  best  case  for  the  protective  tariff,  is  the 
so-called  infant  industry  argument.  The  more  careful 
thinkers  who  advance  this  argument  admit  that  protec- 
tion involves  a  cost,  a  temporary  loss  of  productive  power. 
They  admit  that  it  involves  turning  industry  from  a 
more  productive  into  a  less  productive  line.  But  they 
urge  that  the  newly  established  line  may  be  only  tempo- 
rarily less  productive  and  may  be  eventually  more  pro- 
PART  n— K 


130    ECONOMIC  ADVANTAGES  OF  COMMERCE 

ductive  and  advantageous  for  the  country  than  the 
older  lines  of  industry.  It  is  urged  that  a  country  may 
have  natural  advantages  adequate  to  the  successful 
carrying  on  of  a  given  industry,  but  that,  at  the  begin- 
ning, the  competition  from  more  experienced  manage- 
ment and  better  trained  workmen  abroad  is  likely  to 
prevent  the  growth  and  development  of  the  industry, 
and,  therefore,  to  prevent  the  attainment  of  the  greatest 
possible  efficiency  in  it.  Give  such  an  industry  tempo- 
rary protection,  it  is  said,  so  that  it  can  get  a  start, 
and  it  may  eventually  undersell  its  foreign  rivals.  Then 
the  protectionist  country  will  perhaps  realize  a  gain  which 
will  more  than  compensate  for  the  temporary  loss.1 

It  should  be  said,  to  begin  with,  that  this  argument 
for  protection  applies  at  all,  only  in  regard  to  those 
industries  in  which  success  depends  largely  on  acquired 
skill  and  not  merely  on  natural  advantages.  It  is  hardly 
an  argument,  therefore,  in  favor  of  protection  to  much 
else  than  new  manufactures,  and  it  is  not  an  argument 
in  favor  of  perpetual  protection  for  these.  It  is  highly 
probable,  however,  that  in  some  cases,  if  the  industries 
to  be  protected  are  chosen  wisely,  and  are  not  protected 
too  long,  the  desired  results  can  be  attained.  In  the 
United  States,  a  considerable  part  of  the  silk  industry, 
started  by  protection,  seems  eventually  to  have  reached 
a  position  where  it  can  produce  as  cheaply  as  foreign 
concerns  and  where,  therefore,  it  does  not  need  pro- 
tection.2 

But  while  such  suggestions  have  a  great  deal  of  force, 
the  opposing  considerations,  especially  on  the  practical 

1  This  view  was  presented  in  Alexander  Hamilton's  Report  on  Manufactures, 
and  later,  in  Germany,  was  urged  by  Friedrich  List. 

2  Mason,  "The  American  Silk  Industry  and  the  Tariff,"  American  Economic 
Association  Quarterly,  December,  1910,  p.  177. 


SPECIAL  ARGUMENTS  FOR  PROTECTION     131 

side,  are  also  not  without  weight.  In  the  first  place, 
though  new  industries  may  indeed  be  developed  in  this 
way,  yet  they  can  be  thus  developed  only  by  drawing  the 
labor  force  required,  from  other  lines.  It  follows  that 
the  development  of  skill  and  the  progress  of  invention 
in  those  other  lines  may  be  retarded  as  much  as  in  the 
new  lines  they  are  forwarded.  New  ideas  are  less  likely 
to  be  evolved  among  a  few  than  among  many.  And  in 
proportion  as  there  are  more  persons  in  the  new  lines,  there 
are  fewer  persons  in  the  old  lines.  Indeed,  it  is  not 
inconceivable  that  some  of  the  older  industries,  indus- 
tries still  capable  of  further  progress,  may  be  made  so 
comparatively  unprofitable  —  especially  if  their  neces- 
sary machinery  or  materials  are  taxed  by  the  tariff  - 
as  to  be  entirely  given  up.  We  have  already  seen  that 
protection  tends  to  decrease  the  export  trade *  and  that 
it  may,  by  leading  to  rise  of  prices,2  ruin  other  industries.8 
Before,  then,  protection  is  accorded  to  an  infant  or  em- 
bryonic or  projected  industry,  inquiry  should  be  made 
as  to  the  following  points:  first,  as  to  whether  that 
industry  can  be  expected  to  develop  without  such  aid; 
second,  as  to  whether,  if  it  will  not,  such  aid  will  suffice 
to  develop  it  to  a  point  where  it  can  and  will  sell  its 
products  more  cheaply  than  they  can  probably  be  secured 
elsewhere,  and  enough  more  cheaply  to  compensate,  with 
interest,  for  the  loss  incident  to  starting  it ;  third,  as  to 
whether  the  attempt  to  encourage  it  might  not  involve 
a  risk  of  discouraging  other  industries,  which  would 
balance  any  hoped-for  gam. 

In  view  of  all  these  considerations,  it  becomes  impor- 

1  Chapter  IV  (of  Part  II),  §  i. " 

2  Or  a  change  in  value  relations  of  money  systems,  which  acts  similarly. 
»  Chapter  IV  (of  Part  II),  §  6. 


i32    ECONOMIC  ADVANTAGES  OF  COMMERCE 

tant  to  judge  the  fitness  of  the  governing  body  to  apply 
such  a  policy,  decide  upon  its  effects,  and  select  the 
industries  to  be  encouraged.1  It  is  a  special  function  of 
the  enterpriser-capitalist  to  select  for  his  own  investment 
(and  the  investments  of  those  whom  he  influences)  indus- 
tries capable  of  succeeding.  If  he  does  not,  the  principal 
loss  falls  upon  him  and  upon  others  in  like  situation.  The 
community  suffers  only  indirectly  and  incidentally. 
The  enterpriser-capitalist  is  a  product  of  selection. 
His  power  to  direct  industry  into  profitable  chan- 
nels is  due  to  his  possession  of  capital,  or  the  confidence 
of  other  business  men  and  investors,  or  both.  His  pos- 
session of  capital  and  of  this  confidence,  though  some- 
times due  in  part  to  inheritance  from  able  progenitors 
or  relatives,  is  frequently  due,  in  no  small  degree,  to  past 
successes.  He  has  the  power  to  direct  industry  into  those 
lines  which  he  believes  will  pay  best  and  which,  there- 
fore, are  presumably  the  lines  most  needed  by  the  com- 
munity, because  he  has  successfully  so  directed  industry 
in  the  past.  Men  whose  knowledge  of  law  or  politics 
has  made  them  members  of  a  law-making  body  are  not, 
as  a  rule,  the  product  of  the  same  kind  of  selection.  If 
they  were,  the  fact  that  their  own  fortunes  are  not  at 
stake  does  not  conduce  to  caution.  In  case  a  new 
industry  established  by  protection  never  becomes 
profitable,  the  loss  which  its  establishment  causes  falls 
upon  the  general  public  and  not  upon  legislators  as  such. 
Similarly,  in  case  an  industry  is  prematurely  established 
or  in  case  its  establishment  retards  other  industries,  the 
loss  is  that  of  the  public. 

Given  the  present  form  of  our  own  and  other  republican 

1  Cf.  Bastable,  The  Theory  of  International  Trade,  fourth  edition,  London 
(Macmillan),  1903,  p.  140. 


SPECIAL  ARGUMENTS  FOR  PROTECTION     133 

governments,  there  is  a  special  pressure  tending  towards 
unwise  selection  of  lines  to  be  favored.  This  is  the  pres- 
sure of  localities  or,  at  least,  of  large  interests  in  various 
localities.  For  in  republican  government,  legislators 
usually  represent  districts,  states,  or  other  territorial 
units.  When  it  is  proposed  to  encourage  various  indus- 
tries, when  the  idea  of  protection  is  politically  dominant, 
many  and  influential  interests  in  each  state  and  district 
are  likely  to  desire  that  the  industries  of  that  state  and 
district  shall  get  such  help  at  the  general  expense.  The 
tariff  eventually  decided  upon,  the  tariff  to  which  legis- 
lators from  different  sections  can  agree,  is  not  likely  to 
be  one  which  even  attempts,  scientifically,  to  apply  the 
theory  of  infant  industry  protection.  Instead,  it  is 
likely  to  be  a  hodge-podge  of  special  favors,  distributed  ac- 
cording to  the  relative  strength  of  conflicting  interests,  and 
bringing  general  and  long-continued  injury  to  the  public. 
The  longer  such  a  system  continues  and  the  more 
extensive  its  application,  the  greater  are  the  difficulties 
in  the  way  of  its  reform.  More  and  more  industries 
are  built  up  by  tariff  barriers,  and  their  owners  and  work- 
men taught  to  rely  upon  these  barriers  for  protection 
against  foreign  rivalry.  Managerial  effort,  which  might 
otherwise  be  devoted  to  development  of  the  highest 
efficiency,  is  instead  devoted  to  the  exertion  of  political 
pressure.  Every  effort  is  made  by  numerous  interested 
persons  to  retain  and  increase  the  favors  secured.  Those 
engaged  in  the  industries  assisted  are  seldom  ready  to 
consent  to  reduction  of  the  tariff  after  a  period  of  favor- 
itism, however  long,  but  endeavor,  usually,  to  keep  the 
protection  indefinitely.  Proposals  for  reduction  are 
met  by  predictions  of  dire  calamity,  and  strong  opposi- 
tion to  reduction  is  thus  aroused. 


i34    ECONOMIC  ADVANTAGES  OF  COMMERCE 

To  the  suggestion  that  protected  industries  might 
decline  and  die  without  protection,  the  answer  has  been 
made  that  "no  industry  will  ever  be  given  up  except  in 
order  to  take  up  a  better  one,  and  if,  under  free  trade, 
any  of  our  industries  should  perish,  it  would  only  be 
because  the  removal  of  restrictions  enabled  some  other 
industry  to  offer  so  much  better  rewards  that  labor  and 
capital  would  seek  the  latter." 1  There  is  doubtless 
reason  in  the  contention  that,  since  many  persons  have 
invested  capital  in  the  protected  industries  and  since 
many  others  have  acquired  skill  not  equally  useful  in 
other  lines,  relying  upon  a  continuance  of  the  past  policy 
of  our  government,  therefore  the  entire  protective  system 
should  not  be  swept  away  with  one  blow.  Time  should 
be  given  (as,  under  the  tariff  reduction  policy  of  the  present 
administration  at  Washington,  it  is  being  given)  for  ad- 
justment to  new  conditions.  Nevertheless,  the  public 
cannot  be  held  to  have  pledged  itself  or  to  be  under  any 
obligation  to  maintain  indefinitely  the  protective  system. 
Producers  must  be  held  to  have  taken  the  risk  of  change, 
knowing  eventual  removal  of  tariff  duties  to  be  the 
public's  privilege.  Because  the  people  have  been  will- 
ing to  pay  higher  prices  for  goods  during  a  limited 
period,  it  does  not  follow  that  they  are  duty  bound  to 
suffer  an  equivalent  annual  loss  through  all  future  time. 

§7 

The  Argument  that  a  Protective  Policy  should  be  Fol- 
lowed in  Order  to  Diversify  Industry 

It  is  also  sometimes  argued  that  protection  is  of  use 
to  diversify  industrial  activity  within  a  country.  We 

1  Sumner,  Protectionism,  p.  130. 


SPECIAL  ARGUMENTS  FOR  PROTECTION     135 

have  already  seen  that,  while  the  protective  policy 
encourages  protected  industries,  it  may  cause  the 
decline  of  others.  Yet  if  applied  carefully  and  consist- 
ently with  the  object  of  diversification  in  view,  it  is 
probable  that  a  high  tariff  would  increase  the  number 
of  industries  carried  on. 

It  does  not  follow  that  prosperity  would  be  increased. 
There  is  no  special  advantage  in  having  a  larger  number 
of  occupations  carried  on  when  the  average  income  is 
reduced  by  having  them.  As  a  matter  of  fact,  a  large 
country  like  the  United  States,  with  a  wide  range  of 
natural  resources  and  a  versatile  population,  would  be 
certain  to  have  diversified  industry  within  its  borders, 
under  either  protection  or  free  trade.  With  its  mines 
of  coal,  iron,  copper,  etc.,  the  United  States  could  hardly 
fail  to  be  not  alone  an  agricultural  country,  but  a  manu- 
facturing country  as  well. 

§8 

The  Argument  that  Protection  should  be  Applied  as  a 
Means  of  Getting  and  Maintaining  a  Certain  Degree  of 
National  Self-sufficiency 

Not  all  of  the  arguments  for  a  protective  tariff  are 
strictly  economic  in  character.  There  is,  for  instance, 
the  argument  that  protection  should  be  used  to  insure 
national  self-sufficiency.  This  argument,  in  so  far  as 
it  carries  great  weight,  is  of  a  military  significance.  It 
is  urged  that  a  country  at  war  with  another  or  others, 
is  likely  to  have  its  foreign  trade  seriously  interfered 
with.1  If  the  country  in  question  has  relied  on  foreign 

1  It  may,  of  course,  be  interfered  witH  to  some  extent  if  another  country  or 
other  countries,  with  which  it  habitually  trades,  are  at  war.  But  only  a  part 
of  its  foreign  commerce  is  likely,  in  that  case,  to  be  affected. 


136    ECONOMIC  ADVANTAGES  OF  COMMERCE 

trade  for  the  necessaries  of  life,  it  will  be  subject  to  a 
considerable  strain  during  the  war  period,  and  perhaps 
will  be  less  able  to  carry  the  contest  to  a  successful  con- 
clusion. If  it  has  relied  upon  foreign  trade  for  firearms 
and  ammunition,  it  may  be  in  no  better  position.  It  is 
asserted,  therefore,  that  a  country  should  adopt  the 
policy  of  producing  all  necessaries,  including  all  things 
required  for  war  purposes,  within  its  own  borders,  even 
though  to  do  this  brings  economic  loss. 

It  must  be  admitted  that  this  argument,  like  the  argu- 
ment for  protection  to  infant  industries,  is  not  without 
claims  to  a  respectful  hearing.  There  are,  however, 
some  considerations  of  importance  on  the  other  side. 
In  the  first  place,  close  trade  relations,  such  as  are 
more  likely  to  follow  from  a  free  trade  or  from  a  low  tariff 
policy  than  from  protection,  do  much  to  promote  inter- 
national good  feeling  and,  therefore,  to  prevent  the 
occurrence  of  war.  And  in  the  second  place,  even  if 
war  does  occur,  it  may  well  be  that  the  larger  wealth  and 
population  made  possible  by  a  liberal  trade  and  tariff 
policy  will  give  greater  military  strength,  through  the 
larger  fighting  force  which  can  thus  be  supported,  than 
would  any  degree  of  national  self-sufficiency.1 

In  this  connection  we  may  cite  the  case  of  Great 
Britain.  If  national  self-sufficiency  is  imperative,  there 
would  seem  to  be  nothing  which  it  would  be  more 
important  to  produce  in  the  home  country  than  food. 
Had  Great  Britain  persisted  in  a  policy  of  excluding  for- 
eign grain  and  compelled  her  people  to  live  upon  what 
they  could  themselves  produce,  she  would  have  been 
aiming  at  this  ideal  of  self-sufficiency.  Had  Great 
Britain  carried  out  such  a  policy,  however,  her  population 

1  Sumner,  Protectionism,  p.  143. 


SPECIAL  ARGUMENTS  FOR  PROTECTION    137 

could  not  have  become  so  great  by  many  millions  as  it 
has,  nor  could  her  wealth  have  become  so  great.  She 
has  chosen  rather  to  specialize  in  production,  to  import 
foodstuffs,  to  attain  a  numerous  population  and  large 
wealth.  She  is  not,  it  is  true,  self-sufficient  in  time  of 
war.  She  must  rely  for  her  food  upon  lands  across  the 
seas.  But  the  wealth  which  a  free  trade  policy  has 
brought  her  makes  possible  the  maintenance  of  the  most 
powerful  navy  in  the  world,  a  navy  by  means  of  which 
her  commerce  is  protected.  Is  England  not  a  stronger 
nation,  a  richer  nation,  and  a  not  less  independent  and 
happy  nation,  than  she  could  have  been  had  the  contrary 
policy  been  followed  ? 

§9 

Free  Trade  within  the  United  States 

With  the  exception  of  political  or  military  arguments, 
practically  every  consideration  advanced  in  favor  of 
tariff  duties  on  goods  produced  in  foreign  countries, 
could  be  urged  with  no  less  (and  no  greater)  plausibility 
in  favor  of  tariff  duties  levied  by  one  State  or  section 
on  goods  produced  in  another  State  or  section.  Is  it 
suggested  that  we  do  not  wish  to  send  money  out  of  the 
country  and  that  to  do  so  makes  us  poorer  ?  An  exactly 
parallel  argument  would  assert  that  we  should  adopt 
measures  to  keep  money  from  being  sent  out  of  the  State 
or  the  county.  Do  stanch  protectionists  tell  us  that 
to  let  goods  come  in  from  abroad  at  low  prices,  must 
lower  American  wages  ?  If  so,  then  for  Ohio  or  Illinois 
to  let  low-priced  goods  be  imported  from  New  York  or 
from  Pennsylvania,  must  tend  to  make  wages  in  Ohio 
and  Illinois  lower  than  they  otherwise  would  be.  If 
to  shut  out  English  goods  from  the  United  States  makes 


138    ECONOMIC  ADVANTAGES  OF  COMMERCE 

additional  employment  for  American  wage  earners, 
then  to  shut  out  Connecticut  goods  from  Rhode  Island 
must  make  additional  employment  for  Rhode  Island 
wage  earners.  It  is  hardly  necessary  to  pursue  the  com- 
parison further.  Carried  to  its  logical  conclusion,  the 
system  of  protection  would  prohibit  all  trade  and,  there- 
fore, all  the  gain  in  wealth  which  flows  from  trade. 

Fortunately,  the  Federal  Constitution  makes  tariff 
barriers  between  the  different  states  of  the  United 
States  impossible.  If  it  did  not,  we  should  doubtless 
find  some  of  our  states  levying  protective  duties  against 
their  neighbor  states,  as  Massachusetts,  New  York,  and 
Pennsylvania  did  under  the  old  Confederation  of  lySi.1 
As  it  is,  trade  between  the  states  is,  for  the  most  part, 
regarded  with  equanimity.  The  coal  of  Pennsylvania 
is  exchanged  for  the  shoes,  woolen  and  cotton  goods, 
clocks,  etc.,  of  Massachusetts,  Connecticut,  and  other 
New  England  States.  The  wheat,  corn,  and  meat  of 
the  Middle  West,  and  the  cotton,  rice,  and  sugar  of  the 
South,  are  sold  throughout  the  country,  and  the  special 
products  of  other  sections  are  given  in  payment.  When 
improvements  in  transportation  facilities  make  low 
transportation  rates  possible,  we  regard  the  consequent 
reductions  as  cause  for  rejoicing,  because  of  the  stimulus 
thus  given  to  trade.  There  is  no  reasonable  doubt  that 
free  trade  within  the  borders  of  the  United  States  adds 
greatly  to  our  national  prosperity  and  adds,  also,  to  the 
prosperity  of  each  separate  state.  To  widen  this  free 
trade  area,  so  far  as  lies  within  our  power,  would  still 
further  increase  our  economic  welfare. 

1Hart,  Essentials  in  American  History,  New  York  (American  Book  Co.), 
1905,  p.  109. 


SPECIAL  ARGUMENTS  FOR  PROTECTION    139 

§  10 
Ethical  Considerations  Bearing  on  the  Policy  of  Protection 

Before  concluding  this  discussion  of  the  high  tariff 
system,  let  us  consider  briefly  the  moral  issues  involved. 
The  maintenance  of  this  system  means  that  wealth  is 
to  be  gained,  in  the  favored  industries,  not  by  serving 
the  public  well,  not  by  giving  to  the  public  better  goods 
than  could  otherwise  be  secured  or  goods  at  lower  prices 
than  must  otherwise  be  paid,  but  by  depriving  the 
public,  through  influence  on  legislation,  of  such  benefits. 
The  maintenance  of  protection  means  that  political 
influence  calculated  to  injure  the  community  will  often 
bring  larger  returns  to  those  who  wield  it  than  would 
business  carried  on  in  rivalry  with  others  for  the  benefit 
of  the  community.  As  a  consequence,  energies  which 
might  be  devoted  wholly  to  legitimate  business,  that  is, 
to  seeking  profit  through  efficient  service,  spend  them- 
selves instead  in  selfish  political  activity,  in  the  attempt 
to  make  impossible  any  rivalry  in  service  from  foreign 
producers,  in  the  attempt  to  force  higher  prices  from  con- 
sumers, and  so  to  realize,  at  the  expense  of  consumers, 
higher  profits  than  are  earned.  If  the  ideal  of  industrial 
morality  is  that  profit  shall  be  in  proportion  to  service, 
if  to  seek  profit  by  disservice  is  immoral,  then  the  selfish 
attempt  of  private  interests  to  realize  wealth  by  arbi- 
trarily shutting  out  foreign  competitors  through  tariff 
restrictions,  like  the  attempt  to  shut  out  domestic 
competitors  through  seeking  railroad  discriminations, 
violates  this  ideal  and  is  immoral. 


i4o    ECONOMIC  ADVANTAGES  OF  COMMERCE 

§" 

Summary 

In  this  chapter  the  attempt  has  been  made  properly 
to  estimate  the  value  of  most  of  the  standard  arguments 
for  protection.  The  argument  that  protection  increases 
national  prosperity  by  getting  and  keeping  more  money 
in  circulation  in  the  protectionist  country  was  shown 
to  be  fallacious,  since  money  is  not  the  ultimate  or  prin- 
cipal end  of  trade.  The  popular  " wages  argument"  for 
protection,  so  much  used  in  political  campaigns,  was 
shown  to  have  little  better  basis.  Money  wages  tend 
to  be  somewhat  higher  because  of  the  tariff,1  but  real 
wages  are  almost  necessarily  lower.  The  much  feared 
"competition  of  cheap  foreign  labor"  is  beneficial  to 
our  wage  earners  when  it  means  cheap  goods  from  abroad, 
and  is  injurious  to  our  wage  earners  only  when  it  means 
immigration  of  this  cheap  labor.  Those  who  attempt 
to  show,  inductively,  e.g.  by  comparison  of  English  and 
American  wages,  that  protection  makes  wages  higher, 
fail  to  take  other  things,  such  as  relative  density  of 
population,  into  account.  The  argument  that  pro- 
tection increases  the  opportunities  for  employment  was 
likewise  shown  to  be  untenable.  It  increases  employ- 
ment in  any  industry  only  by  making  that  industry  more 
profitable.  But  in  so  doing  it  makes  other  industries 
less  profitable.  Natural  resources  and  accumulated 
capital,  which  make  employment  at  remunerative 
wages  possible,  are  not  increased  by  protective  tariffs. 

The  third  argument  considered  was  the  so-called 
"  home  market"  argument.  This  is  one  of  the  principal 

1  Except,  of  course,  in  the  case  of  unrelated  currencies.  See  Ch.  V  (of  Part 
ID,  §3- 


SPECIAL  ARGUMENTS  FOR  PROTECTION     141 

arguments  by  which  the  farmers'  votes  are  sought  for 
the  protective  policy.  Examination  showed  that  the 
gaining  of  a  home  market  by  protection  involves  the 
losing  of  a  foreign  market  in  whole  or  in  part,  and  that 
the  higher  prices  which  protection  makes  farmers  pay  for 
goods  are  not  compensated  for  by  the  fact,  supposing  it 
to  be  a  fact,  that  those  to  whom  the  money  is  paid  have 
more  money  with  which  to  buy  farm  produce, 
y  An  argument  having,  if  convincing,  more  significance 
at  present  for  Europeans  than  for  Americans,  is  that  in 
favor  of  protection  to  agriculture,  as  security  against 
a  time  when  the  newer  countries  may  be  less  inclined 
to  buy  manufactured  goods  of  and  sell  food-stuffs,  etc., 
to  the  older  ones.  We  saw,  however,  that  if  future  trade 
is  unimpeded  or  is  impeded  only  by  low  tariffs,  the 
older  countries  can  always  have  a  market  for  their  manu- 
factures without  having  to  accept  returns  less  by  much 
more  than  necessary  transportation  costs,  than  those  of 
manufacturing  industries,  and,  therefore,  agriculture, 
in  the  more  largely  agricultural  countries.  Unless  great 
restrictions  on  future  trade  are  feared,  this  argument  for 
protection  to  agriculture  has  little  force. 

Protection  to  infant  industries  has  been  urged,  even 
by  some  careful  thinkers,  as  a  desirable  temporary  policy. 
The  principal  objections  are  practical.  It  is  difficult 
to  be  certain  that  the  development  of  other  industries 
is  not  being  hindered  as  much  as  that  of  the  favored  in- 
dustry is  being  helped.  It  is  difficult  to  be  certain  that 
the  protected  industry  will  eventually  reach  a  point  of 
development  such  that  the  cheapness  of  its  products  will 
repay  the  public  for  the  admitted  temporary  loss.  It  is 
doubtful  if  a  legislative  body  is  usually  competent  to 
select  industries  for  protection,  on  this  principle,  and  it 


i42    ECONOMIC  ADVANTAGES  OF  COMMERCE 

is  probable  that,  in  practice,  political  pressure  from 
interested  parties  in  various  localities  will  play  much  too 
great  a  part.  There  is  danger  that  the  temporary  pro- 
tection will  be  continued  much  longer  than  is  necessary 
or  desirable,  since  its  beneficiaries  seldom  want  to  give 
it  up. 

Protection  is  also  urged  as  a  means  of  diversifying 
industry,  and  it  probably  has  somewhat  this  effect.  Yet 
diversification  can  be  purchased  at  too  great  a  cost. 
And  a  large  country,  with  varied  resources,  is  pretty 
sure  of  a  considerable  diversity  of  industry,  even  without 
protection. 

The  argument  for  protection  to  insure  national  self- 
sufficiency  is,  in  the  main,  a  military  argument.  Na- 
tional self-sufficiency  is  undoubtedly  an  advantage  in 
time  of  war.  So  is  large  population  and  great  wealth. 
Protection  tends  to  increase  the  degree  of  self-sufficiency 
and  to  limit  wealth  and  (consequently)  population.  It 
cannot  be  definitely  asserted,  therefore,  that  protec- 
tion has  often  an  adequate  military  justification.  The 
greater  wealth  and  population  resulting  from  a  free  trade 
policy  may  mean  the  possibility  of  a  larger  army  and 
navy  and  a  greater  safety  from  attack. 

Most  of  the  arguments  for  protective  tariffs  on  foreign 
produced  goods  (though  not,  of  course,  the  military  argu- 
ment) might  be  used  with  equal  plausibility  in  favor  of 
protection  by  one  part  of  a  country  against  goods  pro- 
duced in  another  part.  It  is  generally  taken  for  granted, 
however,  at  least  in  the  United  States,  that  free  intra- 
national  trade  brings  benefit  to  each  separate  state  or 
other  section  of  the  country.  If  so,  free  trade  with  for- 
eign countries  would,  in  the  same  way,  bring  gain  to  the 
nation  as  a  whole. 


SPECIAL  ARGUMENTS  FOR  PROTECTION    143 

The  industrial  and  commercial  ideal  is  that  wealth 
shall  be  gained  by  service  to  the  community  and  not  by 
injuring  the  community.  Tested  by  this  ideal,  the  effort 
of  interested  parties  to  get  protection  for  their  industries 
is  morally  wrong.  For  they  are  endeavoring  to  gain  busi- 
ness and  wealth  by  prohibiting  a  foreign  competition 
beneficial  to  the  public,  instead  of  by  serving  the  public 
better  than  do  their  foreign  rivals. 


CHAPTER  VII 

THE  NATURE  AND  EFFECTS  OF  BOUNTIES 

§i 
Bounties  as  Compared  and  Contrasted  with  Protection 

SOMEWHAT  similar  in  principle  to  an  import  protective 
tariff  is  a  bounty.  A  bounty  is  a  payment  made  at 
intervals  by  government  to  the  persons  engaged  in  some 
industry  which  it  is  desired  to  encourage,  in  proportion 
to  the  quantity  of  goods  turned  out  or  sold  or  in  proportion 
to  the  quantity  exported.  The  purpose  is,  or  purports 
to  be,  the  encouragement  and  development  of  the  industry 
receiving  the  periodic  payment.  A  bounty  is  like  pro- 
tection in  that  it  tends  to  divert  industrial  activity  into 
a  different  line  or  lines  than  such  activity  would  other- 
wise follow.  Thus,  to  use  our  previous  illustration, 
Canada  could,  by  means  of  a  bounty  as  well  as  by  pro- 
tection, encourage  Canadian  production  of  linen.  The 
beet  sugar  industry  in  continental  Europe  has  been, 
largely,  so  encouraged.  Likewise,  by  means  of  bounties 
or  so-called  shipping  subsidies,  a  number  of  countries 
have  endeavored  to  build  up  their  shipping  interests.1 

On  the  other  hand,  the  bounty  differs  in  several  re- 
spects, in  its  application,  from  protection.  To  begin 
with,  a  protective  tariff  encourages  an  industry  by  guar- 
anteeing it  the  home  market,  i.e.  by  shutting  out  goods 
from  abroad.  But  a  bounty  does  not  attempt  to  inter- 

1  See  discussion  of  shipping  subsidies  in  Ch.  VIII  (of  Part  II),  §  2. 
144 


THE  NATURE  AND  EFFECTS  OF  BOUNTIES     145 

fere  with  foreign  competition.  It  endeavors,  rather, 
to  enable  the  home  producer  more  easily  to  meet  foreign 
competition.1  The  one  method,  protection,  directly 
shuts  out  rivals.  The  other  method  provides  home 
producers  with  the  means  to  drive  out  rivals. 

It  follows,  as  a  second  and  related  distinction,  that, 
while  a  protective  tariff  enables  the  protected  producers 
to  charge  more  for  their  goods,  a  bounty  puts  the  favored 
producers  in  a  position  to  sell  their  goods  for  less  than 
they  could  otherwise  afford  to  take.2  It  is  thus  that 
these  producers  are  enabled  to  capture  the  business. 
A  bounty  may,  because  of  this  difference  from  protec- 
tion, divert  industry  out  of  its  natural  channels  to  a 
greater  degree  than  a  protective  duty.  For  the  latter 
can  do  no  more  than  guarantee  the  home  market  to  pro- 
ducers who,  since  they  need  protection  at  home,  are 
unlikely  to  get  any  considerable  business  elsewhere; 
and  in  fact,  protection,  by  causing  inflow  of  money  and 
higher  money  costs,  is  likely  to  have  the  effect  of  making 
invasion  of  foreign  markets  more  difficult  than  before. 
But  the  former,  a  bounty,  may  make  it  possible  for  an 
industry,  through  competition  in  lower  prices,  to  capture 
the  markets  of  the  world,  though  very  probably  at  great 
expense  to  the  taxpayers  of  the  bounty-paying  country. 

Third,  the  burden  of  protection  falls  upon  the  buyers 
of  protected  goods  in  proportion  to  their  purchases  of 
these  goods;  while  the  burden  of  a  bounty  falls  upon 
taxpayers  in  proportion  to  their  respective  contributions 
to  the  tax  fund.  Protection  compels  consumers  to  pay 
higher  prices.  A  bounty  compels  citizens  to  pay  higher 
taxes. 

i  Cf.  R.  Meeker,  History  of  Shipping  Subsidies  (in  Publications  of  the  Ameri- 
can Economic  Association,  August,  1905),  p.  172. 
^  Ci.  ibid.,  p.  173- 

PART   II L 


146    ECONOMIC  ADVANTAGES  OF  COMMERCE 

§2 

The  Various  Possible  Effects  of  Bounties  on  the  Level  of 

Prices 

The  effect  of  a  bounty  on  the  general  level  of  money 
prices  in  the  bounty-paying  country  is  similar  to  that 
of  protection.  We  may,  for  the  purposes  of  our  discus- 
sion, distinguish  three  cases.  In  the  first  case,  the 
bounty  acts  like  a  protective  tariff  in  that  it  decreases 
imports.  Thus,  Canada  might  have  a  bounty  of  43 
cents  a  yard  or  slightly  more,  on  linen  cloth,  which  would 
enable  the  Canadian  cloth  producers  to  sell  at  home  for 
$i  or  slightly  less  a  yard,  instead  of  $1.43.  As  a  conse- 
quence, we  may  suppose,  the  Canadian  cloth  producers 
would  be  able  to  get  complete  control  of  the  home  market. 
Then,  as  in  the  case  of  protection,  no  money  would  flow 
to  Ireland  or  elsewhere,  for  linen.  But  foreign  con- 
sumers would  still  buy  Canadian  wheat,  and  there  would 
be  a  tendency  for  prices  in  general,  in  Canada,  including 
the  price  of  linen,  to  rise.1  Eventually  Canadian  prices 
would  be  enough  higher  than  before,  as  compared  with 
foreign  prices,  to  bring  back  equilibrium  in  trade.  If 
Canada's  currency  system  were  unrelated  to  the  systems 
of  other  countries,  if,  for  example,  it  were  based  on  incon- 
vertible paper,  the  rise  of  money  prices  would  not  take 
place,  but  equilibrium  of  trade  would  eventually  result 
through  a  change  in  the  relative  values  of  Canadian  and 
other  currencies.2 

In  the  above  assumed  case,  we  have  supposed  a  bounty 
not  quite  high  enough  to  make  it  easy  or  perhaps  possible, 

1  This  might  lead,  as  in  the  case  of  protection,  to  a  demand  for  a  greater 
bounty,  or  to  a  demand  for  bounties  to  industries  previously  not  encouraged. 
See  Ch.  IV  (of  Part  II),  §  6. 

J  See  Part  I,  Ch.  VI,  §§  6,  7,  8,  9,  and  Part  II,  Ch.  IV,  §  3. 


THE  NATURE  AND  EFFECTS  OF  BOUNTIES     147 

for  Canadian  linen  producers  to  meet  transportation  costs 
and  invade  foreign  markets.  Let  us  now  suppose  a 
bounty  of  60  cents  a  yard.  With  a  production  cost  of 
$1.43,  this  bounty  would  reduce  the  net  cost  to  83  cents 
a  yard.  Even  after  paying  transportation  costs,  Cana- 
dians could  then  perhaps  sell  linen  abroad  for  85  or  90 
cents  a  yard,  thus  greatly  increasing  their  business  and 
driving  out  foreign  competitors.  In  this  case,  not  only 
would  Canadian  importation  of  linen  be  decreased,  but 
Canadian  exportation  of  linen  would  be  greatly  increased. 
As  a  consequence,  there  would  be  a  net  inflow  of  money 
into  Canada  and  a  relative  rise  of  Canadian  prices.  This 
rise  would  continue  until  equilibrium  became  estab- 
lished either  by  larger  purchases  of  Canadians  abroad, 
or  by  smaller  purchases  of  foreigners  in  Canada,  or  by 
both.  Thus,  Canadians  might  even,  if  prices  should 
rise  sufficiently,  buy  goods  abroad  which  they  had  pre- 
viously produced  at  home.  If  so,  other  Canadian  pro- 
ducers would  clamor  for  bounties  or  for  protection. 
Nevertheless,  an  equilibrium  of  trade  must  eventually  be 
established.1 

The  third  case  would  be  realized  if,  at  the  time  of  es- 
tablishing a  bounty  on  linen  manufacture,  Canada  was 
already  largely  supplying  the  world  with  linen  and  could 
not  hope  greatly  to  extend  her  foreign  market.  In  this 
case,  the  effect  of  the  bounty  (assuming  free  competition 
among  present  and  potential  Canadian  linen  producers) 
would  be  to  lower  the  price  of  linen  without  correspond- 
ingly increasing  its  sale.  Less  money  would  therefore 
flow  into  Canada,  while  as  much  as  before  would  flow 
out.  Other  things  equal,  there  would  be  a  net  outflow 
of  money,  and  money  prices  would  fall.  It  hardly  needs 

1  Cf.  Ch.  IV  (of  Part  II),  §  6. 


148    ECONOMIC  ADVANTAGES  OF  COMMERCE 

to  be  stated  that,  if  Canada's  money  system  is  assumed 
to  be  different  from  those  of  other  countries,  there  would 
be  a  change  in  the  value  of  Canadian  money  in  terms  of 
other  money,  rather  than  a  fall  in  Canadian  prices.1 

§3 

The  Various  Possible  Effects  of  Bounties  on  the  General 
Welfare  in  the  Bounty-paying  Country  and  in  the 
Countries  with  which  it  Trades 

Consideration  of  the  effects  of  a  bounty  on  the  general 
welfare  of  the  bounty-paying  country  and  of  the  countries 
with  which  it  trades,  may  profitably  follow  the  line  of 
the  above  three  cases.  In  the  first  case,  where  it  decreases 
imports  by  enabling  the  home  producers  to  gain  the  home 
market  but  does  not  enable  them  to  gain  a  foreign 
market,  the  bounty  acts  substantially  like  a  protective 
tariff.  It  tends  to  prevent  imports  but  not  to  stimulate 
exports.  It  conduces  to  national  self-sufficiency.  It 
prevents  what  would  else  be  a  profitable  trade.  Like 
protection,  it  turns  labor  and  capital  away  from  the  chan- 
nels they  would  naturally  follow,  away  from  what  are 
presumably  the  most  profitable  channels,  into  channels 
favored  by  law.  The  effects  on  total  production  are 
obviously  the  same,  whether  diversion  is  caused  by  pro- 
tection or  by  bounty. 

Not  only  is  the  bounty-paying  country  injured,  but 
also  the  countries  with  which  it  trades  are,  presumably, 
to  some  extent  injured.  These  other  countries  lose  a 
profitable  export  trade,  and  they  do  not  secure  goods 
more  cheaply  from  the  bounty-paying  country  since  the 
bounty  is  not  high  enough,  in  the  first  case  discussed, 

1  See,  particularly,  Part  I,*Ch.  VI,  §§  6,  7,  8. 


THE  NATURE  AND  EFFECTS  OF  BOUNTIES     149 

to  encourage  sales  abroad  by  the  recipients  of  this 
bounty. 

The  second  case  to  be  considered  is  that  in  which  the 
bounty  encourages  export  by  the  bounty-paying  country, 
of  the  goods  on  which  the  bounty  is  paid.  If  desired, 
the  bounty  may  be  paid  only  on  exported  goods.  In 
this  second  case,  as  in  the  first,  the  prosperity  of  the 
bounty-paying  country  is  made  less  than  it  otherwise 
might  be.  Industry  is  turned  from  more  profitable 
into  less  profitable  channels.  Trade  with  other  coun- 
tries is  not  prevented  to  the  extent  that  it  is  in  the  first 
case  or  in  the  case  of  protection,  and  may  be  actually 
increased.  But  the  trade  stimulated  is  not  relatively  a 
profitable  trade.  The  export  of  linen  by  Canada,  in 
our  illustration,  takes  the  place  of  other  exportation  more 
profitable  to  Canada  or  of  internal  trade  which  would 
be  more  profitable.  It  is  as  uneconomical  to  encourage 
a  trade  which  would  not  otherwise  take  place,  as  to  dis- 
courage, by  protection  (or  by  high  export  taxes),  trade 
which  otherwise  would  take  place. 

The  effect  of  the  bounty  on  other  countries  than  the 
one  which  pays  it,  is,  in  this  second  case,  beneficial. 
We  know  that  other  countries  would  gain  by  the  trade 
if  the  new  industry  were  one  which  became  established 
in  the  bounty-paying  country  because  of  suddenly  dis- 
covered natural  resources  or  because  of  acquisition  of 
skill.  And  as  far  as  other  countries  are  concerned, 
the  bounty  has  the  same  effect  as  either  of  these  other 
causes  of  development  of  the  favored  industry.  It  is 
no  longer  desirable  for  them  to  produce  the  goods  in 
question  for  themselves.  These  goods  can  be  got  more 
cheaply  at  the  expense  of  the  taxpayers  of  the  bounty- 
paying  country.  The  persons  in  other  countries,  who 


i5o    ECONOMIC  ADVANTAGES  OF  COMMERCE 

formerly  produced  these  goods,  must,  it  is  true,  change 
their  occupation.1  But  there  are  presumably  other 
occupations  equally  or  almost  equally,  profitable,  and  the 
consumers  of  these  other  countries  gain,  therefore,  more 
than  the  producers  lose.2 

In  the  third  case,  the  bounty  does  not  appreciably 
increase  the  sales  abroad  by  the  favored  producers  of  the 
bounty-paying  country,  but  simply  results  in  their  selling 
about  the  same  quantity  of  their  goods  at  lower  prices. 
In  this  case,  the  loss  to  the  bounty-paying  country  is 
more  obvious  than  in  the  other  cases,  while  it  is  even 
clearer  than  in  the  second  case,  that  foreign  countries 
gain.  Since  the  bounty  simply  lowers  prices  without 
extending  trade,  it  benefits  foreign  consumers  without 
driving  any  foreign  producers  from  the  line  of  produc- 
tion favored  into  other  lines.3 


1  The  trade  between  second  and  third  countries  and  their  relative  gains  from 
trade,  may  be  affected.    A  bounty  on  the  production  of  linen  in  Canada  may, 
by  encouraging  export  of  Canadian  linen,  drive  Irish  manufacturers  out  of,  say, 
the  German  market.    Irish  linen  producers  are  injured.     German  linen  con- 
sumers are  benefited.     But  Ireland  can  get  its  own  linen,  thereafter,  more 
cheaply  by  importing  it  from  Canada,  and  gains  in  so  far  as  linen  is  desired  to 
use.    Ireland  is  injured  in  so  far  as  Canada  enters  trade  as  her  competitor  in 
selling  linen  to  Germany,  but  this  loss  is  balanced  by  Germany's  gain.    Ireland 
gains  in  so  far  as  she  secures  linen  from  abroad  more  cheaply  than  she  could 
make  it  herself.    It  becomes  more  economical  for  Ireland  to  devote  herself  to 
some  other  line  or  lines.    If  the  new  products  which  she  now  endeavors  to  ex- 
port are  less  desired  abroad  than  the  old,  the  rate  of  trade  will  tend  to  become 
somewhat  less  favorable  to  Ireland  and  more  favorable  to  these  other  countries, 
than  before.    Ch.  II  (of  Part  II),  §  2.     Ireland  will  also,  probably,  become  some- 
what more  self-sufficient.  But  the  conclusion  remains  that  when  all  other  countries 
except  the  bounty-paying  country  are  considered,  the  general  result  is  favorable. 
See,  however,  Ch.  IV  (of  Part  II),  §  6. 

2  See  Ch.  IV  (of  Part  II),  §  2. 

8  There  is  a  tendency,  also,  for  the  rate  of  trade  to  become  more  favorable 
to  other  countries  and  less  so  to  the  bounty-paying  country.  Money  flows  out 
of  the  latter  and  into  the  former.  Prices  fall,  relatively,  in  the  latter  and  rise, 
relatively,  in  the  former,  though  this  change  would  probably  be  slight  in  the 
case  of  a  bounty  on  only  one  kind  of  goods.  Hence,  foreign  countries  may  be 


THE  NATURE  AND  EFFECTS  OF  BOUNTIES     151 

England  was  for  a  long  time  a  very  great  gainer  by 
virtue  of  the  export  bounties  paid  on  beet  sugar  until 
I903,1  by  the  beet  sugar  producing  countries  of  conti- 
nental Europe. 

Had  only  one  such  country  adopted  a  bounty-paying 
policy,  the  effect  would  have  been  much  larger  exports 
of  sugar  for  that  country  and  a  slightly  lower  price  of 
sugar  for  buying  countries.  This  is  the  kind  of  situation 
discussed  in  our  second  case.  But  when  all  the  Euro- 
pean beet  sugar  countries  were  simultaneously  paying 
bounties  on  exported  sugar,  the  net  result  was  that  no  one 
of  them  could  extend  its  export  trade  to  anything  like 
so  great  a  degree,  while  all  of  them  had  to  accept  very 
low  prices  for  their  product.  There  was  then  a  closer 
approximation  to  the  conditions  described  in  our  third 
case,  though  probably,  since  beet  sugar  largely  displaced 
cane  sugar  from  the  West  Indies  and  elsewhere,  the  con- 
ditions of  case  3  were  not  realized. 

However  this  may  have  been,  it  is  obvious  that  the 
sugar  consumers  of  other  parts  of  the  world  were  great 
gainers  by  virtue  of  these  bounties,  and  gainers  at  the 
expense  of  the  bounty-paying  countries.  Particularly 
did  the  bounties  redound  to  the  profit  of  free-trade 
England,  whose  people  were  not  prevented  by  tariff 
restrictions  from  securing  the  sugar  cheaply.2  So  it 
resulted  that  the  English  were  able  to  consume  several 
times  as  much  sugar  per  capita  as,  for  instance,  the 

able  to  buy  other  goods  than  the  favored  kind  more  cheaply  than  before  from 
the  bounty-paying  country,  while  having  higher  money  incomes  with  which  to 
buy. 

1  Fisk,  International  Commercial  Policies,  New  York  (Macmillan),  1907,  p. 

137- 

2  Although  eventually,  because  of  colonial  sugar  interests  in  the  West  Indies, 
England  supported  the  general  agreement  to  discontinue  the  bounty  competi- 
tion.   It  does  not  follow,  of  course,  that  England  acted  wisely  in  so  doing. 


iS2    ECONOMIC  ADVANTAGES  OF  COMMERCE 

bounty-paying  Germans.1  Furthermore,  all  those  Brit- 
ish industries  which  depended  upon  the  use  of  sugar 
prospered  in  a  large  degree.2  In  the  confectionery  and 
preserving  trades,  thousands  of  persons  were  employed 
and  many  thousands  of  tons  of  sugar  were  annually  used. 
If,  in  some  distant  future,  the  philosophy  of  protec- 
tionism comes  ever  upon  the  discredit  which  it  deserves, 
the  descendants  of  those  whose  taxes  supported  the 
favored  business  of  sugar  production  may  at  least  con- 
sole themselves  with  the  thought  that  many  foreigners 
were  benefited.  Though  the  bounties  turned  industry 
from  its  natural  channels,  though  they  caused  the  con- 
sumption of  beet  sugar,  when  cane  sugar  would  have 
involved  a  less  labor  cost,  though  they  diminished  the 
economic  well-being  of  the  world  as  a  whole,  though 
part  of  the  taxpayers'  burdens  was  therefore  in  every 
sense  a  net  loss ;  yet  another  part  of  their  burdens  was 
compensated  for  by  extra  gains,  in  the  form  of  cheaper 
sugar,  to  the  people  of  a  neighbor  nation. 

§4 

The  Various  Possible  Effects  of  Bounties  on  Wages  and  Rent 

A  bounty,  or  system  of  bounties,  would  usually  affect 
money  wages  as  compared  with  real  wages,  just  as  does 
a  protective  tariff.  The  immediate  effect  of  a  bounty 
would  be  to  tax  the  people  more  than  it  lowered  the 
price  of  the  goods  favored.  For  illustration,  suppose 
that  Canada  can  buy  linen,  in  Ireland,  for  $i  a  yard, 
while  the  cost  of  linen  produced  in  Canada  is  $1.43. 
By  granting  a  bounty  of  43  cents  or  of  53  cents,  the 

1  Sumner,  Protectionism,  New  York  (Holt),  1885,  p.  81. 
*Ibid.,  p.  86. 


THE  NATURE  AND  EFFECTS  OF  BOUNTIES     153 

Canadian  government  enables  home  manufacturers  to 
sell  linen  at  $i  or  at  90  cents  a  yard.  The  people  of 
Canada  lose,  as  taxpayers,  43  cents  to  gain  nothing,  or 
53  cents  to  gain  10  cents.  Unless  the  taxes  are  so  levied 
that  they  do  not  fall  upon  and  cannot  be  shifted  to  wage 
earners,1  real  wages  must  be  lower.2  This  remains 
true  after  the  inflow  of  money  which  raises  prices  (or  the 
outflow  —  case  3  —  which  lowers  prices) .  For  money 
prices  and  money  wages  will  tend  to  be  affected  in  equal 
proportion  by  the  change  in  money  supply.  A  bounty 
on  exports  only,  may  lower  the  price  of  the  favored  goods, 
to  foreign  consumers,  at  the  expense  of  taxpaying 
citizens  of  the  bounty-giving  country,  while  it  will  not 
lower  the  price  to  domestic  consumers. 

§5 

Why  Bounties  may  be  Less  Objectionable  than  Protection 
if  Encouragement  of  Infant  Industries  is  in  Any  Case 
to  be  Attempted 

The  bounty  method  has  sometimes  been  recommended 
as  superior  to  the  method  of  protection,  for  the  estab- 
lishing and  developing  of  an  infant  industry.  Since  the 
bounty  system  is  more  clearly  seen  to  involve  taxation, 
public  support  is  less  likely  to  be  given  to  schemes  for 
its  widespread  application.  It  is  perhaps  not  quite  so 
unlikely  that  care  will  be  used  in  deciding  upon  the 
industry  or  industries  to  be  favored.  For  the  same  rea- 
son, the  likelihood  that  the  bounty  will  remain  a  perma- 
nent burden  upon  the  general  pub  lie  may  be  somewhat  less. 

1  Even  if  the  necessary  taxes  fall  in  no  sense  upon  wage  earners,  and  so  really 
raise  wages,  they  raise  wages  less  by  turning  labor  into  unprofitable  lines  than 
if  the  money  were  directly  paid  to  wage  earners,  as  a  forced  charity. 

«  There  is,  however,  as  with  protection,  a  conceivable  exceptional  case.  Cf . 
Ch.  V  (of  Part  II),  §  5- 


154    ECONOMIC  ADVANTAGES  OF  COMMERCE 

§6 

Summary 

A  bounty,  like  protection,  is  a  special  favor  granted 
by  government  to  some  industry  or  industries.  It 
differs  from  protection  in  that  it  does  not  tax  foreign 
competition,  but  enables  the  domestic  producer  to  meet 
it,  in  that  it  lowers  instead  of  raises  the  'price  of  the 
favored  goods,  and  in  that  the  burden  falls  upon  tax- 
payers as  such  rather  than  upon  consumers.  A  bounty 
may  simply  insure  domestic  producers  their  home  mar- 
ket, or  it  may  be  high  enough  to  enable  them  to  meet 
transportation  costs  and  increase  their  foreign  business, 
or  it  may  enable  them  to  sell  the  same  amount  of  goods 
abroad  as  before,  at  lower  prices.  In  the  first  two  cases, 
the  level  of  prices  in  the  bounty-paying  country  will 
rise  as  compared  with  the  levels  in  the  countries  with 
which  it  trades.  In  the  third  case,  the  level  of  prices  in 
the  bounty-paying  country  will  fall.  In  all  three  cases, 
the  effect  on  the  national  prosperity  of  the  bounty-pay- 
ing country  will  almost  certainly  be  unfavorable.  In  the 
second  and  third  cases,  other  countries  will  be  likely  to 
profit  to  some  extent  at  the  expense  of  the  taxpayers  in 
the  bounty-paying  country.  Since  a  bounty  system 
tends  to  burden  the  taxpayers,  with  no  corresponding 
gain  to  the  general  public,  it  tends  to  lower  real  wages, 
for  it  can  hardly  be  supposed  that  wage  earners  will  be 
unaffected  by  the  level  of  taxation.  If  an  infant  indus- 
try is  in  any  case  to  be  established,  however,  the  bounty 
method  may  be  better  than  the  method  of  protection. 


CHAPTER  VIII 

UNECONOMICAL  GOVERNMENT  INTERFERENCE  WITH,  AND 
ENCOURAGEMENT  OF,  TRANSPORTATION 


Navigation  Laws 

ONE  of  the  important  methods  which  governments 
have  sometimes  followed  in  order  to  develop  a  national 
mercantile  marine,  has  been  the  method  of  navigation 
acts,  excluding  foreign  vessels  from  certain  designated 
commerce.  For  example,  England's  navigation  acts 
of  1646  to  1660  (act  of  1651  perhaps  of  chief  importance), 
prohibited  the  importation  of  any  goods  into  England  or 
Ireland  or  any  of  the  British  Colonies,  except  in  British 
ships,  owned  and  navigated  by  British  subjects,  or  in 
ships  of  the  country  where  the  goods  were  produced; 
also  these  laws  prohibited  the  export  to  foreign  ports  of 
any  goods  produced  in  the  American  colonies,  except 
in  British  ships.1  Our  own  Federal  law  regarding  the 
coasting  trade  is  of  the  same  genus.  This  law  requires 
that  "no  merchandise  shall  be  transported  by  water, 
under  penalty  of  forfeiture  thereof,  from  one  port  of  the 
United  States  to  another  port  of  the  United  States, 
either  directly  or  via  a  foreign  port,  or  for  any  part  of  the 
voyage,  in  any  other  vessel  than  a  vessel  of  the  United 
States."  2 

1  See  Lindsay,  History  of  Merchant  Shipping,  London  (Low,  Low  and  Searle), 
1847,  Vol.  II,  pp.  182-189. 

2  30  Stat.  L.  ch.  26,  p.  248.    Referred  to  in  the  Report  of  the  Commis- 
sioner of  Corporations,  on  Transportation  by  Water  in  the  United  States,  Part 


156     ECONOMIC  ADVANTAGES  OF  COMMERCE 

Such  navigation  acts  are  closely  analogous  to  protec- 
tive tariffs.  Like  protection,  they  develop  the  favored 
home  industry  by  excluding  foreign  competition,  not, 
as  in  the  case  of  the  bounty,  by  providing  funds  to  help 
meet  this  competition.  Like  protection,  these  laws  can 
do  no  more  than  guarantee  home  patronage ;  they  can 
not  insure  successful  invasions  of  other  commerce,  de- 
pendent solely  on  foreign  patronage.  As  with  protec- 
tion, the  burden  of  these  laws  rests  upon  consumers  (of 
goods  carried  in  the  protected  ships),  rather  than  upon 
taxpayers  as  such.  The  burden  rests  upon  consumers, 
because  the  exclusion  from  the  designated  commerce, 
of  ships  presumably  able  to  carry  goods  more  cheaply 
than  the  favored  domestic  ships,1  tends  towards  high 
transportation  rates,  and,  therefore,  towards  higher  prices 
to  consumers,  of  goods  carried,  or  towards  decrease  of 
domestic  commerce,  or  both.  The  burden  of  such  a 
policy  may  not  be  equally  distributed  over  a  country 
enforcing  it,  but  may  rest  with  especial  weight  upon  those 
sections  of  the  country  which,  being  on  or  near  the  coast 
line,  have  most  to  gain  from  cheap  water  transportation. 
A  navigation  policy  like  that  established  by  the  historic 
navigation  laws  of  England,  above  mentioned,  may  also 
tend,  by  increasing  transportation  costs,  to  limit  the 
export  trade  of  the  country  adopting  such  a  policy.  Only 
in  case  other  countries  have  no  available  alternative 
source  of  supply  for  goods  desired,  can  the  extra  cost  of 

I,  1909,  pp.  118,  119.  Since  the  above  was  written,  Congress  has  passed  a  law 
(August,  1914)  admitting  foreign-built  ships  to  American  registry  if  owned  or 
purchased  by  Americans  (See  New  York  World,  Aug.  18,  1914).  Such  ves- 
sels were  not  previously  ranked  as  American  and  had  to  sail  under  alien  flags. 
But  the  new  law  does  not  permit  foreign-built  ships  to  engage  in  the  coasting 
trade. 

1  If  the  latter  carried  goods  more  cheaply,  they  could  drive  out  foreign  rivals 
without  legal  aid. 


ENCOURAGEMENT  OF  TRANSPORTATION     157 

carrying  these  goods  rest  as  a  burden  on  the  consumers 
of  those  other  countries. 

The  main  argument  against  navigation  laws  is  the  same 
as  that  against  protection.  Like  protection,  it  diverts 
labor  and  capital  from  lines  which  they  would  otherwise 
follow,  into  relatively  unprofitable  lines.  These  laws  are, 
therefore,  as  indefensible,  economically,  as  are  protec- 
tive tariffs.  Where  navigation  laws  would  be  likely  to 
develop  a  national  marine,  able,  eventually,  to  compete 
in  the  world's  commerce  successfully  without  aid,  there 
is  a  reasonable  probability  that  conditions  are  favorable 
to  this  success  and  that  it  would  be  attained  in  time 
without  government  coddling.  Where,  in  spite  of  navi- 
gation laws  intended  to  develop  a  national  marine,  abil- 
ity to  compete  outside  of  the  protected  limits  is  never 
attained,  the  protective  laws  involve  a  continuous  burden 
on  the  general  public.  Whatever  military  justification 
may  exist  for  such  protection  to  national  navigation, 
economic  justification  is  usually  absent,  and  is  probably 
always  of  doubtful  weight. 

§2 

Subsidies  to  Native  Shipping 

Another  method  of  encouraging  a  national  mercan- 
tile marine  is  that  of  paying  so-called  shipping  subsidies. 
Shipping  subsidies  are  simply  bounties  paid  to  the  ship- 
ping industry.  What  was  said  in  Chapter  VII  (of  Part  II) 
regarding  bounties  applies,  therefore,  to  shipping  subsidies. 
Like  bounties  and  like  protective  tariffs,  shipping  sub- 
sidies divert  national  industry  out  of  its  natural  lines 
into  a  line  which,  without  such  encouragement,  it  prob- 
ably would  not  follow,  or  which  it  would  not  follow  to 


158    ECONOMIC  ADVANTAGES  OF  COMMERCE 

the  same  extent.  Unlike  protection,  subsidies  do  not 
exclude  foreign  competition,  but  simply  endeavor,  by 
money  payments,  to  make  it  possible  for  the  national 
marine  to  meet  this  competition.  As  with  other  bounties, 
therefore,  the  burden  falls  upon  taxpayers,  rather  than 
upon  shippers  or  ultimate  consumers.  The  two  last 
classes  may  even  gain  somewhat,  if  a  subsidy  is  sufficient 
to  cause  lower  freight  rates  in  spite  of  the  greater  cost  of 
transportation  in  native  ships.  But  even  these  classes 
will  gain  nothing  if  a  subsidy  is  just  high  enough  to  en- 
able native  ships,  previously  unable  to  compete,  to  charge 
rates  no  higher  (and  no  lower)  than  those  charged  by 
foreign  ships. 

One  of  the  cruder  arguments  for  subsidies,  as  for  pro- 
tective tariffs,  is  to  the  effect  that  when  we  patronize 
foreign  vessels  we  have  to  send  our  money  abroad,  and 
that  we  would  "  save  "  this  money  if  we  carried  the  freight 
in  our  own  vessels.  As  a  matter  of  fact,  money  is  not 
the  one  thing  for  which  trade,  in  the  last  analysis,  is 
carried  on.  Furthermore,  if  money  flows  out  unduly,  it 
thereupon  begins  to  flow  back  again,  in  accordance  with 
the  principles  which  we  have  so  often  set  forth  in  previous 
chapters.1  As  regards  the  most  economical  directions 
of  industrial  and  commercial  development,  it  should 
be  apparent  that  if  British  or  other  ships  can  carry  goods 
more  cheaply  than  our  own  merchant  marine,  then  our 
labor  may  better  be  devoted  to  the  lines  where  it  yields 
greater  returns,  to  services  which  others  cannot  so  well  per- 
form for  us,  to  our  factories,  farms,  mines,  and  railroads. 
If  American  labor  is  more  profitable  when  devoted,  for 
instance,  to  the  running  of  railroad  trains,  then  it  is  poor 
economic  policy  to  draw  it,  by  subsidies,  into  the  running 
of  ships. 

1  See,  for  example,  Part  I,  Ch.  V,  §§  6,  7,  8. 


ENCOURAGEMENT  OF  TRANSPORTATION     159 

Another  argument  for  subsidies  is  based  on  the  asser- 
tion that  "  trade  follows  the  flag."  This  assertion,  used 
in  relation  to  subsidies,  suggests  that  a  national  merchant 
marine  acts  as  a  species  of  advertisement,  that,  for  ex- 
ample, the  American  flag  flying  at  the  mast  head  of  a 
merchant  ship  will  stimulate  a  desire  in  South  America 
or  elsewhere,  to  examine,  and,  therefore,  eventually  to 
buy,  American  goods.  Except  for  purposes  of  adver- 
tisement, foreign  ships  serve  as  well  to  carry  American 
goods  to  market  as  do  American  ships,  and  better  in 
proportion  as  they  carry  these  goods  more  cheaply. 

Probably  there  is  some  advertisement  for  a  country's 
goods  in  the  ubiquitousness  of  its  merchant  ships.  Yet 
we  must  beware  of  exaggerating  the  amount  and  the 
value  of  this  advertisement,  and  of  overlooking  its  cost. 
France  has  made  considerable  effort  to  develop  shipping 
and  has  hoped  thereby  to  develop  foreign  commerce, 
while  the  United  States  has  done  almost  nothing  to  stim- 
ulate foreign  trade  in  American  ships ;  yet  a  practically 
stationary  foreign  commerce  of  the  former  country  has 
been  contemporaneous  with  an  extensive  growth  of  the 
commerce  of  the  latter.1  "The  history  of  the  world's 
commerce  seems  to  show  conclusively  that  the  nation- 
ality of  ship  owners  is  quite  a  secondary  matter  in  the 
development  of  trade." 

So  far  as  the  presence  of  a  nation's  ships,  e.g.  American 
ships,  on  the  high  seas  and  in  foreign  harbors,  really  tends 
by  its  advertisement  to  stimulate  American  export 
trade,  it  would  seem  that  the  persons  having  to  pay  for 
this  advertisement  should  be  those  who  expected  to 
reap  special  gain  from  it.  Why  should  not  merchants 

1  Meeker,  History  of  Shipping  Subsidies  (in  publications  of  the  American 
Economic  Association,  August,  1905),  P-  213.  2  Ibid. 


160    ECONOMIC  ADVANTAGES  OF  COMMERCE 

and  manufacturers  who  are  interested  in  exploiting  the 
trade  of  any  part  of  the  world,  and  who  seriously  think 
that  the  presence  there  of  vessels  flying  the  American 
flag  will  bring  them  a  larger  market,  be  willing  to  sub- 
scribe to  the  stock  of  American  lines,  or  pay  a  little  extra 
to  have  their  goods  carried  in  American  vessels,  or  both  ? 
Is  it  not  possible  that  American  merchants  and  manu- 
facturers will  not  do  this  to  any  great  extent,  because  the 
gain  would  be  so  small  as  not  to  equal  the  cost  ?  Hard- 
headed  business  men  spend  a  great  deal  of  money  in  ad- 
vertising. Some  of  them  are  enthusiastic  over  the  as- 
sumed gains  of  this  particular  kind  of  advertising  if  it 
is  proposed  that  it  shall  be  done  at  public  expense  by 
means  of  subsidies.  But  would  they  consider  the  rather 
problematical  results  of  such  indirect  and  indefinite 
advertising  worth  paying  for  out  of  their  own  business 
profits?  By  the  subsidy  method,  many  persons  and 
many  sections  of  the  country  are  taxed  to  secure  results 
which  may  be  of  little  or  no  benefit  to  them  and  which 
are  probably  of  not  very  much  benefit  to  any  one. 

Another  argument  in  favor  of  subsidies  is  one  that 
corresponds  to  the  infant  industry  argument  for  protec- 
tion. It  is  urged,  in  this  view,  that  subsidies  should 
be  given  to  divert  industrial  and  commercial  activity 
more  largely  into  shipping,  in  the  hope  that  the  mer- 
chant marine  will  develop  in  efficiency  until  it  is  able  to 
stand  alone.  An  important  counter-argument  is  the  fact 
that  no  one  is  able  to  foresee  with  any  certainty  whether 
or  not  the  shipping  industry  ever  can  stand  alone  and 
that  legislators  are  less  likely  to  risk  the  public  wealth 
wisely  than  business  men  are  to  risk  their  own.  There 
is  great  danger  that  subsidies,  once  started,  would  con- 
tinue indefinitely  on  the  plea  that  they  continued  to  be 


ENCOURAGEMENT  OF  TRANSPORTATION     161 

necessary.1  And  if,  as  a  consequence  of  a  subsidy  system, 
the  national  mercantile  marine  should  become  larger, 
though  at  the  general  expense,  then  the  political  pressure 
to  maintain  the  subsidy  system  would  very  probably 
become  greater.  It  is  altogether  too  probable  that  if 
the  giving  of  subsidies  is  generally  recognized  as  a  proper 
function  of  government,  men  who  would  otherwise  de- 
vote themselves  to  planning  improvements  and  to  seek- 
ing real  progress  in  efficiency,  will  instead  devote  them- 
selves to  influencing  political  action,  in  order  that  they 
may  get,  or  maintain,  or  increase,  a  subsidy.2  This 
method  of  acquiring  gain  is  not  consistent  with  the  ideal 
of  industrial  and  commercial  morality.  Industry  and 
commerce  should  be  so  organized  that  profits  will  be  made 
only  by  serving  the  public,  and  that  profits  will  be  large 
to  any  person  or  firm  in  proportion  as  that  person  or  firm 
serves  the  public  well.  The  prosperity  of  those  engaged 
in  operating  a  nation's  merchant  marine  ought  not  to  be 
made  dependent  upon  their  political  influence  rather  than 
upon  their  economic  service. 

Apart  from  purely  economic  considerations,  shipping 
subsidies  are  sometimes  urged  as  a  means  of  increasing  a 
nation's  naval  strength.  Two  principal  naval  reasons 
are  commonly  given  for  the  maintenance  of  a  merchant 
marine,  even  at  the  expense  of  a  subsidy.  The  first  is 
the  desirability  of  having  a  " naval  reserve"  made  up  of 
large  and  swift  merchant  steamers  suitable  for  conver- 
sion into  cruisers,  colliers,  and  transports,  should  need 
for  such  arise.  As  a  matter  of  fact,  it  is  only  as  colliers 
and  transports  that  such  vessels  are  likely  to  be  useful, 
since  ships  of  war  are  nowadays  highly  specialized,  and 

1  Meeker,  History  of  Shipping  Subsidies,  p.  81. 

2  Ibid.,  p.  216. 
PART  II  —  M 


162    ECONOMIC  ADVANTAGES  OF  COMMERCE 

merchant  vessels  cannot,  economically,  be  made  over 
into  cruisers.1  The  second  reason  is  the  desirability  of 
having  experienced  seamen  from  whom  to  recruit  colliers, 
transports,  and  additional  righting  ships  when  war  threat- 
ens, to  replace  those  killed  and  wounded,  to  hold  cap- 
tured vessels,  etc. 

These  objects  may  be  perfectly  justifiable,  even  laud- 
able, in  themselves.  And  it  may  be  cheaper  to  pay 
subsidies  to  certain  lines,  thus  helping  to  keep  them  in 
ships  and  men  capable  of  emergency  use  by  government, 
but  letting  them  be  mainly  supported  by  commerce, 
than  to  support,  continuously,  and  wholly  at  public  ex- 
pense, a  larger  naval  force.  But  if  the  policy  of  sub- 
sidizing ships  appears  necessary  to  us  for  military 
reasons,  we  should  frankly  recognize  that  this  policy 
involves  an  economic  loss,  that  it  is  an  expense  borne 
for  the  same  purpose  as  the  expense  of  maintaining  a  navy. 
We  should  not  deceive  ourselves  into  the  belief  that  the 
subsidizing  of  ocean  navigation  is  an  economically  profit- 
able policy.  We  should  therefore  aim  to  get  the  largest 
military  result  possible  at  the  smallest  possible  cost. 
Large  payments  to  swift  mail  lines  and  possibly  to  cer- 
tain other  ships  constructed  for  speed  and  carrying  ca- 
pacity and  conforming,  in  other  ways,  to  possible  emer- 
gency requirements,  mark  the  limit  beyond  which  we 
should  not  go  in  subsidizing,  even  if  we  should  go  so  far. 
Subsidies  granted  according  to  these  principles  are  pay- 
ments for  certain  definite  services  or  potential  services, 
and  are  not  to  be  classed  with  subsidies  granted  for 
purely  commercial  reasons. 

1  Meeker,  History  of  Shipping  Subsidies,  p.  215. 


ENCOURAGEMENT  OF  TRANSPORTATION    163 

§3 

Indirect  Subsidies,  Favoring  Native  Ships  as  Compared 
with  Foreign  Ships 

A  country  may  try  to  extend  and  develop  its  own 
merchant  marine,  to  the  consequent  decrease  (or  slower 
increase)  of  the  number  of  foreign  ships,  by  indirect  as 
well  as  by  direct  subsidies.  Any  service  which  a  coun- 
try, through  its  government,  performs  for  its  own  ships 
without  pay,  while  charging  foreign  vessels  for  it,  is 
equivalent  to  a  money  subsidy. 

Were  it  not  for  clear  treaty  obligations,  there  would 
probably  be,  in  the  United  States,  as  strong  a  demand 
for  free  use  of  the  Panama  Canal  by  all  of  our  American 
merchant  ships,  as  there  has  actually  been  for  its  free 
use  by  American  vessels  engaged  in  the  coasting  trade.1 
To  let  American  vessels  use  the  Panama  Canal  free  would 
be  equivalent  to  a  money  subsidy,  because  it  would 
amount  to  the  same  thing  as  to  make  a  charge  for  the 
use  of  the  canal  and  then  to  make  a  payment  equalling 
this  charge,  to  American  shipping  interests.  In  either 
case,  the  taxpayers  of  the  nation  would  bear  a  burden, 
or  lose  a  chance  for  lower  taxes,  that  special  interests 
might  be  encouraged.  For  if  letting  American  ships 
use  the  canal  free  would  mean  that  the  canal  could  never 
pay  a  reasonable  return  on  its  cost,  then  taxpayers  must 
meet  the  deficit  by  taxes  paid  to  government  over  a 
series  of  years,  in  order  to  liquidate,  or  at  least  pay  in- 
terest upon,  the  indebtedness  caused  by  building.  If, 
on  the  other  hand,  though  all  American  ships  used  the 
canal  free  of  tolls,  the  amounts  collected  from  foreign 

1  For  a  discussion  of  the  economic  advisability  of  giving  American  coasting 
lines  this  special  privilege,  see  §  4  of  this  chapter  (VIII  of  Part  II). 


164    ECONOMIC  ADVANTAGES  OF  COMMERCE 

ships  would  suffice  to  pay  interest  on  the  debt  contracted, 
still  this  interest  might  be  had  and  more  besides,  were 
the  American  lines  also  made  to  contribute.1  In  other 
words,  to  allow  American  ships  free  use  of  the  canal  must, 
in  any  case,  mean  either  a  loss  or  a  smaller  net  revenue 
yielded  to  the  government  than  might  otherwise  be 
yielded.  If  the  canal  is  to  yield  the  nation  a  revenue 
because  of  its  use  by  foreign  ships,  that  revenue  should 
be  used  to  lighten  the  burden  of  taxation  on  the  whole 
people ;  it  should  not  be  used  to  encourage  a  single  in- 
dustry by  giving  it  something  for  nothing.  Thus  to  en- 
courage American  shipping  would  be  to  give  it  an  artifi- 
cial advantage  over  other  American  industries,  and  would 
be,  in  so  far,  to  interfere  with  the  tendency  of  labor  and 
capital  to  engage  in  the  industries  really  most  profitable 
for  the  nation.  There  is  no  economic  gain2  in  having 
our  commerce  carried  in  American  ships  if  foreign  ships 
are  able  to  carry  it  more  cheaply.  Nor  would  the  pros- 
perity of  the  nation  as  a  whole,  including  those  who  bear 
the  burden  of  taxation,  be  so  much  furthered  by  having 
our  commerce  carried  in  American  ships  which  could 
pay  little  or  nothing  for  the  use  of  the  canal,  as  by 
having  it  carried  in  foreign  vessels  which  could  pay  a 
reasonable  amount  for  its  use  without  charging  corre- 
spondingly higher  transportation  rates.  Assuming  these 
to  be  the  relative  abilities  of  native  and  foreign  vessels, 

1  It  is  not  intended  to  assert  that  either  American  or  foreign  ships  should  be 
charged  exorbitant  rates.     Such  rates  on  ships  carrying  American  commerce, 
of  whatever  nationality  the  ships  might  be,  would  tend  to  discourage  this  com- 
merce, even  when  it  could  pay  the  proper  costs  of  its  own  movement  and  would 
therefore  be  profitable.    As  to  the 'effect  on  American  welfare  of   exorbitant 
rates  charged  ships  not  carrying  American  commerce,  see  footnote  at  end  of  this 
section. 

2  Unless  we  assume  a  gain  from  the  advertisement  thus  secured.     See  §  2  of 
this  chapter  (VIII  of  Part  II). 


ENCOURAGEMENT  OF  TRANSPORTATION    165 

the  foreign  vessels  would  be  a  more  economical  means 
for  us  of  carrying  our  commerce  than  our  own;  for 
them  to  carry  it  would  mean  either  lower  rates  and, 
therefore,  lower  prices  to  consumers  and  higher  prices 
to  producers,  or  larger  returns  to  the  government,  favor- 
able to  taxpayers,  or  both  such  lower  rates  and  higher 
prices ;  for  them  to  carry  our  commerce  would  mean  gain 
to  our  people  as  producers  and  consumers,  or  as  tax- 
payers, or  as  both.  It  would  be  desirable,  therefore, 
for  our  capital  and  labor  to  seek  other  kinds  of  activity ; 
but  this  is  just  what  discrimination  in  the  rates  charged 
for  use  of  the  canal  would  prevent.1 

§4 

The  Free  Use  for  Navigation  of  Government-built  Canals 

Since  to  give  free  use  of  the  Panama  Canal  to  all  Amer- 
ican ships  and  to  no  others,  seemed  clearly  to  involve 
a  violation  of  treaty  obligations,  Congress  was  content, 
in  the  Panama  Canal  Act  of  1912,  to  confer  this  privi- 
lege only  upon  American  ships  engaged  in  the  coasting 
trade.  Even  this  lesser  tolls  exemption  appeared  to 
many  to  be  a  violation  of  treaty  rights;  and  the  law 
has  recently, 2  at  the  request  of  President  Wilson,  been 
changed  in  this  regard  so  as  to  require  the  same  charges 
from  American  coasting  vessels  as  from  all  other  mer- 
chant ships.  We  shall  discuss,  here,  the  possible  eco- 

1  Were  we  to  plan/intelligently,  so  to  discriminate  in  rates  charged  for  use  of 
the  Panama  Canal,  as  to  pay  for  it,  as  largely  as  possible,  at  the  expense  of  for- 
eigners, we  would  base  the  discrimination  on  the  sources  and  destinations  of 
goods  carried,  rather  than  on  the  nationality  of  the  ships  which  carried  them. 
Goods  going  to  and  from  the  United  States  would  be  allowed,  perhaps,  to  pass 
through  the  canal  at  fairly  low  rates,  lest  American  consumers  or  producers  be 
unduly  taxed ;  while  goods  going  from  one  foreign  country  to  another  would  be 
charged  the  highest  rates  possible  to  collect. 

'June,  1914. 


i66    ECONOMIC  ADVANTAGES  OF  COMMERCE 

nomic  effects  of  tolls  exemption  for  American  coasting 
ships.  As  we  have  already  seen,1  the  Federal  govern- 
ment assures  American  vessels  a  monopoly  of  the  coast- 
ing trade,  including  the  trade  from  any  port  of  the  United 
States  to  any  other  port,  e.g.  from  Baltimore  to  San 
Francisco.  Free  use  of  the  Panama  Canal  by  American 
vessels  engaged  in  the  coasting  trade  could  not,  there- 
fore, increase  our  mercantile  marine  at  the  expense  of 
foreign  rivals  in  the  trade.  The  primary  effect  of  free 
tolls  to  this  special  class  of  ships  would  be  to  reduce  the 
expense  of  coast  to  coast  trade,  and  therefore,  supposedly, 
to  reduce  rates.  Possibly  foreign  vessels  could  carry  at 
the  lower  rates,  even  without  free  tolls.  If  the  coasting 
trade  were  open  to  foreign  ships,  the  effect  of  discrim- 
ination in  favor  of  American  vessels  engaging  in  this 
trade  might  simply  be  that  the  American  ships  would  be 
able  to  get  part  of  the  trade  away  from  their  foreign 
competitors,  at  substantially  the  same  rates.  As  it  is, 
such  free  tolls  would  tend  to  make  rates  lower  than  they 
would  else  be,  though  much  of  the  saving  might  be  di- 
verted to  the  owners  of  monopolistic  navigation  com- 
panies. Hence  traffic  would  be  encouraged  to  go  through 
the  canal,  which  otherwise  would  not. 

The  construction  of  a  canal  across  the  Isthmus  of 
Panama,  to  be  used  without  charge  by  American  coasting 
vessels,  would  therefore  mean  that  traffic  from  the  East 
to  the  West,  and  vice  versa,  which  is  not  worth  the 
whole  cost  of  carrying,  might  nevertheless  be  carried 
at  the  expense  of  the  tax-paying  public.  If  it  is  worth 
$5000  to  get  certain  goods  from  New  York  to  San  Fran- 
cisco, and  the  cost  of  carriage,  including  proper  payment 
for  all  necessary  facilities,  is  $6000,  and  if  this  cost  is 

1  §  I  of  this  chapter  (VIII  of  Part  II). 


ENCOURAGEMENT  OF  TRANSPORTATION    167 

covered  by  the  charge  made,  the  goods  will  not  be  sent. 
It  will  be  more  economical  to  have  a  greater  degree  of 
local  self-sufficiency  and  less  geographical  division  of 
labor.  But  if  the  taxpayers  should  contribute  more 
than  $1000  in  the  form  of  maintenance  and  running 
cost  of  the  canal,  and  interest  on  its  cost  of  construction, 
then  the  goods  would  be  shipped,  for  the  charge  to  the 
shippers  could  be  made  less  than  $5000.  The  total  cost 
would  be  $6000  and  the  total  gain  would  be  $5000. 
There  would  be  a  real  net  loss.  But  this  loss  would  be 
borne  by  the  taxpayers,  and  therefore  the  traffic  would 
be  carried. 

Again,  the  encouragement  of  the  coasting  trade  by 
the  building  of  an  Isthmian  ship  canal  to  be  used  by 
coasting  vessels,  free  of  charge,  might  mean  that  goods 
would  be  carried  by  water  or  partly  by  water,  at  the  tax- 
payers' expense,  which  might  be  more  economically 
carried  by  rail.  Suppose  that  a  quantity  of  goods  can 
be  shipped  from  New  York  to  Salt  Lake  City  by  rail  for 
$4000,  including  a  proper  allowance  for  wages  of  em- 
ployees and  something  towards  profits.  Suppose  that, 
at  the  same  time,  the  cost  by  water  and  rail,  including 
risk,  damage,  longer  time  in  transit,  maintenance  cost 
of  the  canal  and  interest  on  canal  facilities  provided, 
is  $5000.  $1000  may  be  saved  if  the  goods  go  by  rail, 
and  to  make  them  go  by  the  other  route,  if  we  include 
interest  on  the  cost  of  partly  constructing  this  route  for 
them,  maintenance  expenses,  etc.,  would  be  to  waste 
$1000.  The  community  or  the  nation  would  be  so  much 
poorer,  yet  if  the  government  were  to  provide  the  $1000 
or  more  in  the  form  of  canal  facilities  paid  for,  eventually, 
by  the  taxpayers,  shippers  would  gain  by  using  the  water- 
way route. 


i68    ECONOMIC  ADVANTAGES  OF  COMMERCE 

It  is  not  asserted,  of  course,  that  all  goods  ought  to 
pay  in  the  same  proportion  to  use  the  canal,  if  discrimi- 
nations should  prove  to  be  practicable.  If  the  plant 
is  incompletely  utilized,  it  may  not  be  improper  to  let 
some  goods  go  through  for  comparatively  low  rates, 
provided  they  would  not  otherwise  go  at  all.  But  no 
goods  ought  to  be  allowed  to  go  through  which  cannot 
pay  at  least  a  fair  share  towards  running  expenses,  wear 
and  tear  from  use,  and  (probably)  a  little  towards  inter- 
est. And  the  canal  should  not  have  been  built  (mili- 
tary considerations  aside1),  unless  it  was  expected  that 
the  traffic  through  it,  as  a  whole,  would  be  enough  cheaper 
to  pay  interest  on  it.  To  build  it,  if  it  could  not  be  made 
to  pay,  was  economic  waste,  was,  as  above  pointed  out, 
to  encourage  transportation  not  really  worth  its  total 
cost  to  the  people.  Now  that  the  canal  is  completed,  it 
would  be  unfair  to  the  American  people  as  a  whole  that 
the  traffic  which  goes  through  it  should  not,  if  possible, 
pay  for  it,  that  those  who  realize  the  chief  benefit  should 
not  contribute  in  proportion  to  the  benefit  realized. 

Here,  as  in  the  case  of  protection,  we  meet  the  possibil- 
ity that  government  interference  with  the  direction  of 
industry  may  affect  differently  the  people  of  different 
sections,  benefiting  some  at  the  expense  of  others.  It  is 
obviously  only  that  part  of  our  population  living  on  or 
reasonably  near  the  coast,  which  has  much  to  gain  from 
subsidizing,  directly  or  indirectly,  coast  to  coast  water 
transportation.  Those  living  in  the  far  interior  will,  in 
any  event,  have  to  rely  mainly  on  other  means  of  trans- 
portation. Yet  by  the  scheme  of  indirect  subsidizing 
under  discussion,  but  which  has,  fortunately,  been  aban- 

1  As  a  matter  of  fact,  it  is  hardly  to  be  doubted  that  economic  considerations 
had  great  weight  in  inducing  its  construction. 


ENCOURAGEMENT  OF  TRANSPORTATION     169 

doned,  those  in  the  interior  would  be  made  to  contribute 
to  the  cost  of  facilities  of  transportation  which  others 
use  and  which  they  cannot  use  in  the  same  degree.1 

The  principles  above  elaborated  apply  equally  when 
government  builds  canals  in  the  interior,  if  traffic  is  al- 
lowed to  use  these  canals  free  of  charge.  New  York 
State  is  now  enlarging  the  once  busy  and  profitable  Erie 
Canal  at  an  estimated  cost  of  not  less  than  $100,000,000, 
in  order  that  it  may  carry  barges  of  1000  tons  capacity 
from  the  Atlantic  Ocean  to  the  Great  Lakes  and  vice 
versa.  The  plan  is  to  charge  nothing  for  the  use  of  the 
canal.  This  will  mean  a  burden  on  the  taxpayers  of 
the  state,  an  uncompensated  loss  to  the  taxpayers  in 
those  parts  of  the  state  which  cannot  economically  use 
the  canal  either  to  market  their  produce  or  to  obtain 
goods  for  consumption.  It  amounts  to  a  gift  by  the  tax- 
payers of  the  state  of  New  York  to  those  producers  and 
consumers  in  other  states,  who  can  sell  their  products  for 
more  or  buy  desired  goods  for  less,  because  of  the  free 
use  of  the  Erie  Canal.  It  involves  encouragement  to 
transportation  via  the  canal  of  goods  which  might  better 
go  by  railway  or  by  the  St.  Lawrence  river.  If  the  traffic 
which  is  expected  to  use  the  canal  would  be  able  to  pay 
the  cost  of  operation  and  maintenance,  and  interest  on 
the  $100,000,000  or  more  sunk  and  to  be  sunk,  then  it 
should  be  charged  this  cost  and  interest,  to  the  end  that 
those  who  reap  the  benefit  of  the  canal  in  lower  cost  of 
carriage,  and  in  prices  of  goods  higher  to  producers  and 
lower  to  consumers,  shall  pay  for  the  advantage  so  se- 

1  An  excuse  for  such  discrimination  against  dwellers  in  the  interior  might 
perhaps  be  found  in  the  fact  that  those  living  on  the  coast  chiefly  bear  the  burden 
resulting  from  the  limitation  of  the  coasting  trade  to  American  vessels.  Two 
policies,  each  tending  towards  economic  waste,  would  partially  offset  each  other 
as  regards  inequality  of  effect. 


i;o    ECONOMIC  ADVANTAGES  OF  COMMERCE 

cured;  and  that  those  who  reap  the  most  gain  shall  pay 
the  most ;  and  to  the  end  that  the  burden  shall  not  fall 
upon  the  general  public  without  any  regard  to  propor- 
tionate use  and  to  benefits  received.1  If,  on  the  other 
hand,  it  is  not  believed  that  those  using  the  canal  can 
meet  such  charges  and  still  find  it  profitable  to  carry 
goods  over  it,  then  we  must  conclude  that  the  canal 
ought  not  to  be  (or,  in  part,  to  have  been)  enlarged, 
since  the  total  expenses,  including  cost  of  this  enlarge- 
ment, of  carrying  goods  over  it,  will  probably  be  greater 
than  the  benefits  to  be  received  from  transporting  the 
goods,  or  will  be  greater  than  if  the  goods  were  carried 
over  another  route,  e.g.  a  railroad. 

Before  the  days  of  railroads,  much  confidence  was  felt 
in  the  possibilities  of  canals.  A  number  of  our  states 
expended  a  great  deal  of  money  in  canal  building.  To- 
day it  is  generally  recognized  that,  since  the  capital  cost 
of  canals  is  a  tremendous  initial  expense,  railroads  are 
generally  cheaper.  Only  in  a  comparatively  few  cases 
can  canal  building  be  expected  to  pay.  These  are,  first, 
cases  where  the  canals  connect  navigable  waters  located 
near  to  each  other,  and  between  which,  if  they  are  con- 
nected by  a  canal,  there  will  be  large  traffic ;  second,  cases 
where  comparatively  short  canals,  like  the  Suez  Canal, 
save  a  very  great  sailing  distance  and  so  are  extensively 
used ;  third,  cases  more  doubtful,  where  short  canals  con- 
nect with  the  ocean,  great  cities  which  have  grown  up  not 

1  It  is  no  sufficient  answer  to  this  contention  to  cite  the  usual  practice  regard- 
ing our  numerous  streets  and  roads.  To  charge  tolls,  individually,  on  each 
person  as  he  used  any  given  street,  would  obviously  be  an  intolerable  nuisance. 
These  facilities  we  must  have,  anyway,  and  substantial  justice  may  be  secured, 
if  care  is  taken  to  avoid  extravagance,  by  levying  on  local  property  owners  accord- 
ing to  some  fair  system.  Since  land  values  depend  largely  on  streets,  etc.,  it 
may  be  possible,  by  basing  assessments  or  taxes  on  land  values,  to  make  costs 
to  different  persons  vary,  on  the  whole,  in  proportion  to  benefits. 


ENCOURAGEMENT  OF  TRANSPORTATION     171 

far  from  it.1  "Practically  all  the  canals  now  in  most  suc- 
cessful use  are  ship  canals,  forming  comparatively  short 
links  between  important  natural  waterways,  and  opening 
up  extended  routes  of  transportation  by  water  for  large 
vessels.  Such  short-link  ship  canals  are  to  be  clearly 
distinguished  from  long  inland  canals,  and  the  success 
of  the  one  offers  no  safe  criterion  as  to  the  probable 
success  of  the  other. " 2  Moulton's  study  of  the  much 
vaunted  waterway  system  of  Germany  seems  to  provide 
conclusive  evidence  that  canals  are  as  cheap  as  railways 
for  shippers,  only  if  the  taxpayers,  in  effect,  help  pay  the 
freight,  and  that,  hi  general,  canals  and  canalized  rivers 
involve  tremendous  loss  to  the  nation  which  undertakes 
their  construction,  and  are  therefore  a  source  of  indus- 
trial and  commercial  weakness  rather  than  of  strength.3 
If  there  were  adequate  reason  to  believe  that  canals, 
generally,  were  cheaper  and  more  satisfactory  means  of 
transportation  than  railroads,  it  would  not  be  necessary 
to  have  public  agitation  and  political  pressure  to  get 
canals  built.  Private  companies  would  undertake  to 
build  them  for  profit,  just  as  they  build  railroads  for 
profit,  and  just  as  canals  were  built,  in  England  particu- 
larly, before  the  days  of  railroads.4  As  a  matter  of  fact, 
investors  are  not  clamoring  for  a  chance  to  buy  the  securi- 
ties of  such  companies,  nor  are  promoters  eagerly  looking 
for  opportunities  to  project  new  lines.  When  the  build- 

1  Preliminary  Report  of  United  States  National  Waterways  Commission, 
IQII,  pp.  13,  14.    Reprinted  in  Final  Report,  1912,  pp.  75,  76.    See,  however, 
as  to  an  example  of  the  third  class  of  cases,  viz.  the  Manchester  Ship  Canal, 
Moulton,  Waterways  versus  Railways,  Boston  and  New  York  (Houghton  Mif- 
flin  Co.),  1912,  Ch.  VII. 

2  Report  of  Commissioner  of  Corporations  on  Transportation  by  Water  in 
the  United  States,  Part  I,  p.  45- 

»  Moulton,  Waterways  versus  Railways,  Chs.  IX,  X. 
4  Ibid.,  p.  99. 


172    ECONOMIC  ADVANTAGES  OF  COMMERCE 

ing  of  canals  is  mentioned  favorably,  the  assumption  is 
always  made  that  taxpayers  shall  bear  the  burden,  or 
at  least  the  risk,  of  building  them. 

§5 

The  Improvement  of  Harbors 

Water  transportation  which  is  not  worth  its  cost,  may 
likewise  be  stimulated  by  a  wrong  system  of  harbor  im- 
provement. In  the  United  States,  the  construction  and 
care  of  lighthouses,  the  building  of  breakwaters,  the 
dredging  of  harbors,  and  the  dredging  of  channels  between 
the  sea  and  harbors,  are  done  largely  by  the  Federal  gov- 
ernment.1 It  cannot  be  said  that  nothing  is  paid  to- 
wards the  expenses  involved,  by  the  traffic  aided,  since  the 
tonnage  dues  collected  by  the  government  amount  to 
$800,000  or  $900,000  a  year.2  But  considering  the  fact 
that  the  Federal  government  appropriates  about  $5,000- 
ooo  a  year  for  lighthouse  maintenance  alone,3  and,  on 
the  average,  appropriates  millions  of  dollars  each  year 
for  dredging,  breakwater  construction,  etc.,  the  traffic 
entering  and  leaving  the  ports  of  the  United  States  can- 
not be  said  to  bear  the  costs  which  it  occasions.  Rather 
is  this  traffic,  in  a  considerable  degree,  subsidized  at  the 
expense  of  taxpayers.  As  with  canals,  so  with  light- 
houses and  harbors,  we  must  conclude  that  those  who 
benefit  by  them  should  be  the  ones  required  to  pay  for 
them,  and  that  to  place  the  burden  of  their  construction 

1  Report  of  Commissioner  of  Corporations  on  Transportation  by  Water  in  the 
United  States,  Part  III,  1909,  pp.  39,  40. 

2  Johnson,  Ocean  and  Inland  Water   Transportation,  New  York  (Appleton), 
1911,  p.  252.     Given  in  Report  of  Commissioner  of  Corporations  on  Transporta- 
tion by  Water  in  the  United  States,  Part  I,  p.  404,  as  $1,076,571.69  in  1908. 
The  coasting  trade  is  free  even  from  this. 

3  Ibid.,  p.  262. 


ENCOURAGEMENT  OF  TRANSPORTATION     173 

and  support  on  the  general  public,  with  no  reference  to 
benefit  received,  is  undesirable  and  unfair.1  We  must 
further  conclude  that  constructions  and  improvements 
made  in  harbors,  for  which  the  traffic  using  the  harbors 
cannot  afford  to  pay,  involve  national  economic  loss  and 
ought  not  to  be  undertaken. 

In  many  cases  the  money  spent  in  harbor  improve- 
ments by  the  Federal  government  is  wholly  or  partly 
wasted,  for  appropriations  are  frequently  made  for  which 
there  is  no  economic  justification  and  for  which  there 
would  be  no  economic  justification  even  if  the  largest 
sums  possible  were  to  be  realized  by  charging  the  users. 
Such  wasteful  appropriations  are  doubtless  in  part  due 
to  lack  of  business  sense  among  legislators.  They  are 
perhaps  more  largely  due  to  the  pressure  of  local  interests. 
The  very  fact  that  these  appropriations  are  so  largely 
made  by  the  central  government,  and  that  there  is,  or 
seems  to  be,  a  chance  for  interested  localities  to  get  some- 
thing for  nothing,  results  in  expenditures  which  would 
not  be  made  if  the  localities  particularly  concerned  had 
always  to  provide  the  means,  or  if  private  capital  had  to 
be  induced  to  do  so.2 

1  It  is  not  a  sufficient  answer  to  the  above  argument,  to  assert  that  our  tariff 
system  taxes  trade  and  that  therefore  this  trade  pays  for  itself  by  paying  for 
the  facilities  used.     For  the  burden,  nevertheless,  does  not  fall  where  it  properly 
belongs.     It  does  not  fall  anything  like  evenly  on  all  traffic  which  uses  the  facil- 
ities provided.     On  some  goods  the  tariff  has  been,  until  recently,  prohibitive, 
artificially  interfering  with  normal  and  profitable  trade.     On  other  commerce 
and  on  passenger  traffic,  the  tariff  duties  are  little  or  nothing.    Such  commerce  and 
traffic  may,  in  effect,  be  receiving  a  subsidy,  while  the  remainder  of  commerce 
is  burdened.    The  principle  of  charging  the  cost  of  facilities  provided,  to  those 
who  use  them  and  upon  different  interests  in  some  proper  proportion  to  the 
benefit  received,  is  not  conformed  to.     We  fall  far  short  of  the  economic  ideal 
when  we  set  up  contradictory  policies  of  discouragement  and  encouragement. 
These  contradictory  policies  do  not  exactly  neutralize  each  other,  but  in  one  case 
there  is  a  net  loss  in  one  direction,  and  elsewhere  there  is  a  net  loss  in  another 
direction. 

2  Cf .  Preliminary  Report  of  National  Waterways  Commission,  p.  20  (Final 
Report,  p.  82). 


174    ECONOMIC  ADVANTAGES  OF  COMMERCE 

A  different  system,  and  one  which  is  economically 
more  defensible,  is  that  common  in  Great  Britain.  There 
the  central  government,  except  as  naval  considerations 
may  be  involved,  does  nothing  whatever  by  way  of  har- 
bor improvement,  but  leaves  this  matter  to  the  localities 
immediately  concerned.  The  British  system  of  harbor 
improvement  and  maintenance  requires  the  creation  for 
each  harbor  of  a  so-called  " public  trust"  or  public  harbor 
trust.1  A  public  harbor  trust  is  a  semi-public  body  or  a 
corporation,  authorized  by  parliament,  to  which  body  is 
granted  power  to  own,  improve,  and  manage  a  particu- 
lar harbor.  It  has  been  compared2  to  the  board  of 
trustees  of  an  American  university  or  charitable  institu- 
tion. The  members  receive  no  salaries,  but  regard  their 
position  as  an  honorary  one.  The  composition  of  a 
harbor  trust  is  determined  by  statute.  Representatives 
are  usually  selected  by  the  British  government,  the 
government  of  the  city  concerned,  boards  of  trade  and 
chambers  of  commerce,  ship  owners'  associations,  and 
other  interested  parties.  Money  is  borrowed  for  neces- 
sary improvements,  usually  at  low  rates,  for  the  harbor 
trust  is  authorized  to  collect  port  and  dock  charges  from 
vessels  utilizing  the  facilities  given,  and  this  power  makes 
the  security  good,  at  least  in  the  case  of  a  port  sure  to  have 
large  traffic.  Sometimes  money  is  borrowed  from  the 
municipality  itself.  In  any  case,  money  needed  in  excess 
of  what  has  been  collected  in  previous  years  from  traffic, 
is  borrowed,  and  must  be  paid  back  out  of  future  collec- 
tions. There  are  no  stockholders,  and,  therefore,  there 
is  no  attempt  to  make  a  profit  above  a  fair  interest  and 

1  Described  in  Smith,  The  Organization  of  Ocean  Commerce,  Philadelphia 
(Publications  of  the  University  of  Pennsylvania),  1905,  pp.  129,  130. 


ENCOURAGEMENT  OF  TRANSPORTATION     175 

sinking  fund.  Indeed,  a  private  corporation  authorized 
to  collect  tolls  from  all  the  shipping  of  a  port,  for  the  sake 
of  dividends  to  stockholders,  would,  unless  strictly  regu- 
lated, be  an  intolerable  monopoly. 

But  the  British  system  of  harbor  control  does  make 
the  traffic  pay  for  the  facilities  required,  and  is  in  so  far 
consistent  with  the  economic  principles  so  wisely  applied 
to  British  trade  and  commerce  generally.  There  is  no 
attempt  to  encourage  trade  which  is  not  nationally 
profitable,  by  partly  supporting  it,  i.e.  by  providing  free 
harbor  facilities  at  public  expense  and,  therefore,  at  the 
expense  of  other  lines  of  economic  activity,  any  more 
than  there  is  the  attempt  to  interfere  with  nationally 
profitable  trade  by  high  tariff  duties.  The  public  trust 
unites  responsibility  with  direct  action.  It  furthers 
efficiency,  economy,  and  lowness  of  rates,  but  it  does  not 
subsidize. 

The  function  of  maintaining  lighthouses,  however, 
almost  of  necessity  devolves  upon  a  central  government. 
No  city  or  private  corporation  is  in  a  position  to  perform 
this  function  and  make  the  traffic  benefited  pay  for  the 
service  provided,  since  much  of  the  benefit  will  be  received 
by  vessels  which  have  no  occasion  to  visit  the  particular 
city  or  to  come  within  reach  of  the  particular  corporation. 
The  British  government,  therefore,  maintains  the  light- 
houses, but  collects  " light  dues"  in  return,  amounting 
to  about  $2, 500,000  yearly,  from  vessels  entering  English 
harbors.  These  dues  pay  the  entire  yearly  cost  of  main- 
taining the  lighthouses  and  about  $250,000  a  year  be- 
sides.1 Here,  also,  is  no  policy  of  subsidizing,  no  attempt 

i 

1  Johnson,  Ocean  and  Inland  Water  Transportation,  p.  262.  If  the  slight 
charge  above  yearly  cost  is  criticised,  it  should  be  remembered  that  a  reason- 
able return  on  investment  is  not  an  improper  aim. 


176    ECONOMIC  ADVANTAGES  OF  COMMERCE 

to  foster  one  industry  at  the  taxpayers'  expense,  or  to 
encourage   an   undue   and   uneconomical   geographical 

division  of  labor. 

§6 

The  Improvement  of  Rivers 

The  responsibility  for  the  improvement  of  rivers,  like 
that  for  the  improvement  of  harbors,  has  rested,  in  the 
United  States,  chiefly  with  the  Federal  government. 
The  work  done  has  included  the  removal  of  obstructions 
to  navigation,  the  deepening  of  channels  by  dredging,  the 
construction  of  revetments,  and  the  development  of  slack 
water  navigation  by  the  building  of  locks  and  dams  to 
maintain  a  navigable  depth.  Improvements  of  this  sort 
have  been  carried  out,  to  some  extent,  on  most  of  the 
navigable  rivers  of  the  country.  But  the  appropria- 
tions of  Congress  for  these  purposes  have  not  always 
been  wisely  made,  nor  has  the  distribution  of  improve- 
ments throughout  the  country  been  influenced  solely  by 
commercial  or  economic  considerations. 

Let  us  notice  one  or  two  typical  instances  of  Federal 
activity  in  river  improving.  To  improve  the  Mississippi 
river,  the  government  has  spent,  in  all,  more  than 
IgOjObOjOoo.1  Of  this  amount,  $15,000,000  has  been 
spent  on  the  200  mile  stretch  between  the  mouths  of  the 
Missouri  and  Ohio  rivers.2  But  the  traffic  on  this 
stretch  of  the  river,  including  that  of  St.  Louis  (which 
is  located  between  these  points  near  the  Missouri),  has 
steadily  decreased.  In  1880,  upwards  of  a  million  tons 

1  The  Report  of  the  Commissioner  of  Corporations  on  Transportation  by  Water 
in  the  United  States,  1909,  Part  I,  p.  47,  gives  $97,685,920. 

2  The  facts  and  figures  in  this  and  the  next  paragraph  are  taken  chiefly  from 
an  article  by  Herbert  Brace  Fuller,  in  the  Century  Magazine,  January,  1913, 
pp.  386-395,  entitled  "American  Waterways  and  the  Pork  Barrel." 


ENCOURAGEMENT  OF  TRANSPORTATION     177 

of  freight  were  shipped  from  St.  Louis.  In  1900,  the 
amount  aggregated  only  245,000  tons,  and  in  1911,  only 
191,965  tons.  Is  it  safe  to  assume  that  there  has  been  so 
much  saving  in  the  expense  of  carrying  this  traffic,  as 
compared  with  what  it  would  have  cost  to  carry  it  by 
rail,  or  to  carry  it  on  the  unimproved  river,  as  to  compen- 
sate for  the  money  sunk  ?  Would  those  who  have  used 
this  section  of  the  river  have  been  willing  to  invest, 
jointly,  the  $15,000,000,  in  order  to  have  the  better 
navigation  conditions  which  that  investment  has  made 
possible  ? 

If  there  remains  any  doubt  in  this  case  that  money 
has  been  unwisely  spent,  there  can  be  no  doubt  in  other 
cases  that  public  funds  have  been  wasted  for  the  sake  of 
returns  to  private  interests  and  to  limited  territories, 
almost  incomparably  less  than  the  general  loss.  The  Big 
Sandy  river  is  a  tributary  of  the  Ohio  river.  The  Big 
Sandy  and  its  two  branches  or  tributaries,  the  Tug  and 
Levisa  rivers,  lie  in  Kentucky  and  West  Virginia.  On 
their  improvement,  the  Federal  government  has  spent, 
in  all,  about  $1,700,000.  Excluding  timber,  which  can 
be  and  commonly  is  floated  down-stream,  the  average 
yearly  traffic  on  these  rivers  is  about  2000  tons.  Reck- 
oning interest  on  this  $1,700,000  as  only  $40,000,  or  less 
than  2\  per  cent  a  year,  the  annual  cost  to  the  United 
States  of  providing  facilities  for  this  traffic  is  $20  per 
ton  a  year.  Adding  $20,000  a  year  for  maintenance, 
we  have  a  cost  of  $30  a  ton. 

Average  railroad  charges  in  the  United  States  are  con- 
siderably less  than  one  cent  per  ton  mile.1  For  low 
grade  freight  (the  only  kind  which  makes  much  use  of 

1  Statistics  of  Railways  in  the  United  States,  Interstate  Commerce  Com- 
mission, 1 9 10,  p.  59. 

PART  n  —  N 


178    ECONOMIC  ADVANTAGES  OF  COMMERCE 

inland  waterways)  going  long  distances,  railroad  charges 
average  very  much  less  than  this,  probably  markedly 
less  than  a  half  cent.  The  facilities  provided  by  the 
government  on  the  above  mentioned  three  rivers  would, 
therefore,  have  to  reduce  the  transportation  cost  upon 
them  to  zero,  in  order  that  the  construction  or  invest- 
ment by  the  government  should  be  proved  worth  while, 
unless  the  traffic  benefited  moved  an  average  distance 
of  over  6000  miles.  For  even  at  zero  cost  of  carriage, 
each  ton  carried  one  mile  would  secure  a  saving  of  but 
one-half  a  cent.  And  unless  it  were  carried  6000  miles, 
the  total  saving  would  not  amount  to  the  $30  interest 
and  maintenance  cost. 

What  is  the  reason  for  the  numerous  appropriations  of 
this  sort  made  by  our  government  ?  A  partial  explana- 
tion may  be  found  in  the  current  American  practice  of 
donating  to  commerce  the  improvements  made,  and 
letting  the  general  public  bear  the  burden  in  indirect 
and,  therefore,  hardly  realized  taxation.  Commercial 
interests  are  the  more  ready  to  plead  for  comparatively 
useless  dredgings,  revetments,  and  canalizations,  because, 
however  small  the  benefits  are,  they  reap  these  benefits, 
and  because,  however  heavy  the  cost  is,  others  mainly 
bear  it.  Any  reform  which  goes  to  the  root  of  the  evil 
must  espouse  the  principle  of  making  those  contribute 
most  to  the  fixed  charges  and  maintenance  costs  of  navi- 
gation improvements,  who  chiefly  use  those  improve- 
ments and  to  whom  their  benefits  chiefly  go. 

A  further  partial  explanation  is  suggested  by  noting 
the  distribution,  throughout  the  country,  of  money 
appropriated  for  waterways.  In 'the  general  River  and 
Harbor  Act  of  1910,  appropriations  were  received  by  296 
congressional  districts  in  the  United  States,  out  of  a 


ENCOURAGEMENT  OF  TRANSPORTATION     179 

total  of  391, *  in  other  words,  by  over  three-fourths  of 
such  districts.  Apparently  the  appropriations  were 
given  to  nearly  every  district  in  which  there  was  a  stream 
or  harbor  offering  any  excuse  for  expenditure.  This 
River. and  Harbor  Act  illustrates  what  has  been  called 
the  "pork  barrel"  system  of  waterway  development. 

The  difficulty  is  one  which  seems  to  apply  generally  to 
the  activities  of  a  democratic  government.  A  despotic 
or  aristocratic  government  is  based  on  the  privilege  of 
special  persons  or  classes.  It  governs  largely  in  the  in- 
terest of  legally  privileged  classes.  It  insures  to  those 
classes,  political  and  economic  privileges  maintained  at 
the  expense  of  others.  Such  a  government  was  that  of 
France  before  the  Revolution.  Such  is  that  of  Russia 
to-day.  In  the  case  of  a  popular  government  and  an  in- 
telligent people,  privilege  is  probably  less  excessive,  and 
its  forms  less  obnoxious.  But  there  may  still  be,  espe- 
cially if  the  government  carries  on  industrial  functions 
or  interferes  at  all  with  the  natural  laws  of  trade,  the 
privilege  which  comes  from  bargaining.  One  class 
wants  a  special  kind  of  tariff  law,  adverse  to  the  public 
interest.  Another  class  desires  legislation  subversive 
of  currency  stability,  also  contrary  to  the  general  wel- 
fare. The  representatives  of  each,  in  Congress,  may 
support  the  desires  of  the  other,  in  return  for  counter 
support. 

The  evil  shows  itself  most  of  all,  perhaps,  through  the 
influence  exerted  by  localities  or  by  special  interests  in 
different  localities.  We  have  noted  this  particularly 
in  the  case  of  the  protective  tariff.2  And  just  as,  in  the 
case  of  the  tariff,  congressional  representatives  from 

1  Fuller,  American  Waterways  and  the  Pork  Barrel,  loc.  cit, 

2  Chapter  VI  (of  Part  II),  §  6. 


i8o    ECONOMIC  ADVANTAGES  OF  COMMERCE 

different  states  and  districts  desire,  each,  to  get  or  keep 
a  high  tariff  for  the  goods  produced  in  his  district,  what- 
ever the  effect  on  the  common  weal,  and  sometimes 
inconsistently  with  their  party  platforms,  so  these  repre- 
sentatives desire  appropriations  of  money  to  improve 
waterways,  each  for  his  own  district,  even  though  the  cost 
to  the  country  as  a  whole  far  exceeds  the  benefit,  and 
even  though  each  district  suffers  more  from  its  forced 
contributions  to  improvements  in  other  districts,  than 
it  gains.  There  is,  consequently,  a  process  of  "  log- 
rolling," so-called,  in  which  A  votes  for  B's  project  in 
return  for  support  of  his  own ;  and  the  ultimate  result 
is  an  appropriation  or  set  of  appropriations  having  no 
consistency  and  involving  general  loss. 

Each  Congressman  thus  acting,  feels  that  he  is  gaining 
favor  with  his  constituents.  The  persons  interested  in 
local  waterway  constructions  make  representations  to 
him  regarding  the  importance  of  them.  He  feels  that 
the  people  of  his  district  are  not  concerned  primarily  hi 
having  him  act  the  part  of  a  wise  and  conscientious 
legislator,  careful  not  to  waste  the  nation's  resources, 
but  that  they  are  concerned  rather  in  having  him  "do 
something"  for  them.  If  he  succeeds  in  getting  what  is 
desired,  the  newspapers  of  the  district  publish  the  fact 
that,  through  his  influence,  Congress  has  been  led  to  ap- 
propriate a  sum  to  improve  navigation  on  the  local  stream 
or  to  deepen  the  local  harbor.  The  fault  is  not  alone 
that  of  the  Congressman  who,  under  such  circumstances, 
does  the  thing  which  he  believes  his  constituents  desire, 
but  is  also  largely  the  fault  of  those  constituents  them- 
selves, whose  selfish  local  interests  overshadow  in  their 
minds  the  greater  interests  of  the  nation  of  which  they  are 
a  part,  and  whose  limited  intelligence  will  not  let  them  see 


ENCOURAGEMENT  OF  TRANSPORTATION     181 

that  the  system  practised  is  likely,  in  the  end,  to  hurt 
more  than  to  help  even  their  own  welfare. 

It  would  seem,  then,  that  a  reform  which  would  go  to 
the  root  of  the  difficulty  must  not  only  insist  upon  the 
attempt  to  charge  users  rather  than  taxpayers,  for  facil- 
ities provided,  but  must  also  insist  that  the  entire  first 
cost  and  risk  of  constructing  these  facilities  shall  not  fall 
upon  the  nation  as  a  whole.  If  government  expenditure 
rather  than  private  investment  is  thought  to  be  necessary 
to  improve  certain  waterways,  at  least  the  government 
expenditure  and  risk  should  be  partly  borne  by  localities 
most  directly  concerned.  If  such  localities  will  not 
support  certain  improvements,  themselves,  they  should 
not  expect  the  nation  to  do  so.  If  the  nation  refuses  to 
bear  the  burden  alone,  but  insists,  always,  upon  local  aid, 
there  will  be  far  less  pressure  for  Federal  appropriations, 
and  many  wasteful  expenditures  will  be  avoided.1 

§7 
Subsidies  to  Railroad  Building 

The  subsidizing  of  transportation,  by  government, 
has  extended,  in  the  United  States  (not  to  mention 
other  countries),  to  railroads  also.  The  railroads  of  the 
United  States  have,  it  is  true,  been  built  pretty  largely 
with  private  capital,  but  they  have  also  received  aid 
from  the  national  government,  from  many  of  the  states, 
and  even  from  county  and  city  governments.  The 
states  and  local  governments,  in  some  instances,  invested 
in  railroad  securities,  so  enabling  the  roads  to  get  capital 

1  Cf.  Preliminary  Report  of  National  Waterways  Commission,  pp.  19,  20 
(Final  Report,  pp.  81,  82).  See  also  Report  of  Commissioner  of  Corporations 
on  Transportation  by  Water  in  the  United  States,  Part  I,  pp.  8,  59,  for  reference  to 
European  practice. 


i82    ECONOMIC  ADVANTAGES  OF  COMMERCE 

which,  perhaps,  private  persons  would  have  been  less 
ready  to  provide.  But  the  Federal  government,  in  addi- 
tion to  making  loans,  made  very  extensive  land  grants  to 
companies  constructing  numerous  desired  lines,1  chiefly 
in  the  less  densely  settled  parts  of  the  country,  the  West 
and  Southwest.  The  grants  made  between  1850  and 
1871  turned  over  to  the  railroad  companies  about  159 
million  acres  of  the  public  domain,  an  area  exceeding 
five  states  the  size  of  Pennsylvania.2  So  far  as  the  land 
grant  policy  was  based  on  military  conditions,  we  cannot 
judge  it  on  economic  grounds  alone.  But  so  far  as  it 
can  be  regarded  as  a  commercial  policy,  it  can  be  judged 
in  the  light  of  commercial  principles. 

We  shall  not,  of  course,  be  able  to  decide,  absolutely, 
whether  the  land  grants  and  other  government  aid  to 
the  railroads  actually  decreased  the  total  of  national 
wealth.  So  to  decide,  we  should  have  to  know  not  only 
what  has  happened,  but  just  what  would  have  happened 
if  business  and  transportation  development  had  taken 
its  natural  course.  But  we  can  lay  down  general  prin- 
ciples of  usual  application,  which,  in  the  long  run,  are 
apt  to  be  safest  to  follow. 

To  begin  with,  it  must  be  admitted  that  there  is  such 
a  thing  as  undesirable  transportation.  The  labor  and 
capital  of  a  country  should  be  applied  in  order  of  pref- 

1  See,  on  this  subject,  Haney,  A  Congressional  History  of  Railways  in  the  United 
States,  Vol.  II.    The  Railway  in  Congress :   1850-1887,  Madison,  Wis.  (Demo- 
crat Printing  Co.,  State  Printer),  1910,  Chs.  II,  III.     Also  Sanborn,  Congres- 
sional Grants  of  Land  in  Aid  of  Railways,  Madison  (Bulletin  of  the  University 
of  Wisconsin),  1899,  Chs.  VI,  VII.    A  good  brief  account  is  in  Johnson,  A merican 
Railway    Transportation,    2d    revised  edition,   New  York    (Appleton),   1909, 
Ch.  XXII. 

2  Not  including  land  forfeited  by  failure  to  conform  to  conditions.    The 
granting  of  the  mere  rights  of  way  might  be  regarded  as  analogous  to  the  grant- 
ing of  farms  to  actual  settlers.     But  the  granting  of  millions  of  acres  additional 
cannot  be  so  regarded. 


ENCOURAGEMENT  OF  TRANSPORTATION     183 

erence  to  different  industries  according  to  their  relative 
importance,  according  to  the  relative  need  for  them. 
In  other  words,  the  people  should  devote  their  efforts  to 
the  lines  which  pay  best.  It  may  be  said  that  the  people 
living  in  the  Middle  West  and  Far  West,  where  railroad 
building  was  encouraged  by  government  more  than  in 
the  East,  desired  railroads  as  a  means  of  reaching  eastern 
markets.  But  the  mere  existence  of  railroads  leading  to 
markets  does  not  in  itself  mean  greater  prosperity,  since 
the  benefits  so  received  may  be  appreciably  less  than  if 
the  same  capital  were  invested  in  some  kind  of  produc- 
tive enterprise  for  immediate  local  needs.  Unless  the 
trade  made  possible  by  a  railway  brings  as  much  wealth 
and  prosperity  as  could  have  been  had  by  foregoing  the 
trade  and  producing  more  locally,  unless,  that  is,  as 
much  of  desired  wealth  is  produced  by  the  railway  as 
would  be  produced  were  the  labor  and  capital  applied 
instead  to  the  farms  and  ranches,  to  building  houses, 
making  furniture,  etc.,  the  building  of  the  road  is  not 
economy  for  the  community.  If  a  railroad  when  con- 
structed will  yield  the  people  of  a  community  a  benefit 
equivalent  to  what  the  same  investment  would  yield  in 
another  line,  then  those  who  receive  this  benefit  can 
afford  to  pay,  for  the  use  of  the  railroad,  a  proper  return 
on  the  capital  invested.  If  they  cannot  afford  to  pay 
such  a  return,  it  must  be  because  they  are  not  receiv- 
ing a  correspondingly  valuable  service  and,  therefore,  it 
must  be  that  the  capital  invested  in  the  railroad  is  not 
producing  the  value  which  it  might  have  produced  if 
invested  otherwise. 

If  the  territory  through  which  a  railroad  is  desired  is 
sparsely  settled  and  would  offer  but  small  traffic  in  pro- 
portion to  trackage,  thus  only  very  partially  utilizing 


184    ECONOMIC  ADVANTAGES  OF  COMMERCE 

the  plant  of  the  railroad,  then  high  charges  would  be 
required,  in  order  that  the  railway  plant  might  pay  to 
the  owners  the  average  rate  of  profit  on  investment. 
But  high  charges  may  be  as  serious  preventives  of  reach- 
ing markets  as  absence  of  railroads  leading  to  markets. 
If,  therefore,  only  small  traffic  can  be  hoped  for,  it  may 
be  truer  economy  for  the  territory  concerned  and  the 
various  communities  in  it,  to  be  more  self-sufficient,  to 
depend  more  exclusively  on  natural  waterways,  or  to 
carry  goods  by  using  horses  and  vans,  than  to  build  a 
railroad. 

The  people  of  a  given  section  of  the  country  may 
think  that  they  gain  nothing  by  having  an  incompletely 
utilized  railroad,  if  they  have  to  pay,  in  high  freight  and 
passenger  rates,  interest  on  its  cost.  They  may  not  be 
prepared  to  patronize  such  a  road,  feeling  that  the  ser- 
vice is  not  worth  the  charges.  Yet  if  the  road  is  paid 
for  in  part  by  government  aid,  even  though  they  have  to 
pay  the  taxes  that  make  the  aid  possible,  they  may  de- 
lude themselves  into  thinking  that  they  are  gainers  by 
having  the  railroad.  Nevertheless,  the  people  are  pay- 
ing for  the  service  rendered  just  as  surely  by  this 
method  as  by  the  other,  and  if  it  is  unprofitable  for  them 
to  pay  the  amount  in  the  one  way,  it  is  unprofitable  to 
pay  it  in  the  other.  The  chief  difference  is  that  if  govern- 
ment supports  the  enterprise  without  receiving  any  cor- 
responding return,  the  cost  of  the  service  rendered  is 
paid  for  by  the  people  without  any  regard  to  the  propor- 
tionate benefits  received. 

If  the  assistance  is  by  grants  of  land,  the  essential 
principle  of  the  policy  is  the  same.  The  public  domain 
belongs  to  the  whole  people.  It  rests  with  them  to  give 
it  to  settlers,  to  keep  it  as  forest  reserve  and  for  other 


ENCOURAGEMENT  OF  TRANSPORTATION     185 

purposes,  or  to  secure  money  revenue  by  selling  it.  To 
contribute  it  to  railroad  companies  is  as  much  a  cost  as 
to  contribute  the  equivalent  in  money.1 

As  a  consequence  of  the  land  grant  policy,  capital 
was  diverted  to  transportation  purposes  which  might 
have  yielded  larger  returns  in  agriculture  or  in  manufact- 
ures. In  so  far  as  the  policy  had  this  effect,  it  lessened 
rather  than  increased  national  prosperity.  Because  of 
the  land  grant  policy,  also,  population  tended  to  be  di- 
verted towards  the  Middle  and  Far  West,  while  there 
was  still  room  in  the  East,  South,  and  Central  states. 
As  a  result  of  this  diffusion  of  population,  goods  were 
probably  carried  by  rail  over  longer  distances  than  would 
have  been  necessary  had  population  been  for  a  time 
more  concentrated  and  had  its  extension  westward  been 
more  gradual.  Had  the  westward  movement,  except 
that  by  water  to  the  Pacific  coast,  been  slower,  a  shorter 
connection  could  have  been  kept  by  the  near  frontier 
with  the  more  densely  settled  parts  of  the  country,  and 
the  necessity  of  long  hauls  of  meagre  traffic  through 
undeveloped  sections  could  have  been,  in  part,  avoided. 
It  is  doubtless  true  that  some  sections  of  the  West  are 
exceptionally  rich  and  fertile,  as  some  are  exceptionally 
mountainous  or  arid.  That  the  former  should  event- 
ually hold  a  large  population  was  both  unavoidable  and 
desirable.  But  that  the  movement  westward  should 
have  been  artificially  hastened,  at  the  cost  of  millions 
of  acres  of  the  public  domain,  at  the  cost  of  diverting 
labor  from  other  industries  into  transportation,  at  the 
cost  of  unnecessary  distances  in  transportation,  and  at  the 
cost  of  building  railroads  in  advance  of  traffic,  ought  not 
to  be  too  readily  taken  for  granted. 

1  See,  however,  considerations  later  in  this  section,  especially  in  footnote. 


i86    ECONOMIC  ADVANTAGES  OF  COMMERCE 

«*• 

As  some  parts  of  the  country  presumably  gained  by 
the  policy,  so  other  parts  probably  lost  wealth.  Many 
of  the  eastern  farmers,  for  instance,  found  themselves 
disadvantaged  by  competition  with  producers  of  the 
West.  So  far  as  western  farmers,  by  virtue  of  natural 
advantages,  were  able  to  undersell  the  farmers  of  the 
East,  the  result  was  economical  and  beneficial.  But 
so  far  as  western  farmers  were,  in  effect,  given  bounties, 
by  having  transportation  provided  in  part  at  national 
expense,  the  result  may  very  well  have  been  a  national 
loss.  If  the  prosperity  of  the  government-aided  western 
farmer  was  increased,  that  of  the  eastern  farmer  was 
decreased.  If  the  value  of  western  land  was  raised,  that 
of  eastern  land  was  lowered.1 

One  type  of  municipal  or  local  aid  deserves  particular 
mention.  This  is  aid  which  is  made  conditional  on  the 
choice  of  a  route  through  the  town  or  city  giving  it. 
Such  aid  introduces  an  uneconomical  basis  (from  the 
social  point  of  view)  of  calculation  into  the  choice  of  a 
route.  The  route  selected  is  less  apt  to  be  the  one  which, 
all  matters  of  traffic  and  expense  considered,  is  most 
profitable,  and,  therefore,  socially  most  desirable,  but  is 
apt,  rather,  to  be  a  route  favored  by  the  largest  promises 
of  local  aid. 

1  To  the  argument  that  the  government  so  raised  the  value  of  the  remainder 
of  its  own  land,  it  can  be  answered  that  it  is  not  the  business  of  a  government 
to  depreciate  the  land  of  citizens  in  order  to  raise  the  value  of  public  land.  If 
the  principle  that  land  rent  is  largely  a  social  product  and  belongs  mainly  to 
the  whole  people,  were  commonly  accepted,  depreciating  some  land  to  raise  the 
value  of  other  land  would  appear  clearly  to  be  uneconomical.  It  is  probable, 
in  the  case  under  discussion,  that  enough  railroads  would  soon  have  been  built, 
and  that  the  government,  even  in  the  narrow  sense  here  used,  lost  more  than  it 
gained  by  making  the  grants. 


ENCOURAGEMENT  OF  TRANSPORTATION     187 

.-* 

§8 

Summary 

Let  us  now  briefly  restate  the  principles  set  forth  in 
this  chapter,  regarding  government  interference  with 
and  encouragement  of  transportation.  Navigation  laws 
were  first  considered.  These  laws  attempt  to  develop 
the  national  merchant  marine  by  excluding  foreign  ships 
from  certain  trade.  The  United  States  excludes  foreign 
vessels  from  the  coasting  trade.  Considered  from  the 
purely  economic  viewpoint,  these  laws  are  analogous 
to  protection,  and  for  similar  reasons  they  are  economi- 
cally undesirable. 

Shipping  subsidies  are  in  the  nature  of  bounties.  In 
general  it  may  be  said  that  they  are  without  economic 
justification.  It  may  be  defensible,  however,  or  even 
desirable,  to  make  definite  payments  to  certain  lines  of 
ships,  in  order  to  have  a  claim  to  vessels  as  naval  reserves. 
Subsidies  may  be  indirect,  as  when  certain  privileges  are 
given  to  a  nation's  own  merchant  vessels,  at  the  tax- 
payers' expense,  which  are  denied  to  the  ships  of  other 
nations.  The  purpose  of  discriminating  subsidies,  direct 
or  indirect,  is  not  so  much  to  increase  commerce  as  to 
have  it  carried  in  vessels  of  the  subsidy-paying  country. 

Facilities  for  transportation  are  frequently  provided 
by  government  at  the  taxpayers'  expense.  These  tend 
to  stimulate  commerce  which  is  not  worth  the  expense 
borne,  and  which  could  not  pay  this  expense.  Such  a 
policy  is  unfair  to  the  general  tax-paying  public  and  vio- 
lates the  principle  that  those  who  gain  by  any  facilities 
should  be  the  ones  to  pay  for  them.  Such  provision  of 
commercial  facilities  at  public  expense  would  have  been 
the  carrying  out  of  the  plan  to  allow  United  States  coast- 


i88    ECONOMIC  ADVANTAGES  OF  COMMERCE 

4 

ing  vessels  to  use  the  Panama  Canal  free.  Such  provi- 
sion of  facilities  at  public  expense  is  the  plan  to  have  the 
Erie  Canal  forever  free  from  tolls.  Sections  of  the  country, 
or  of  the  state  of  New  York,  which  have  little  or  nothing 
to  gain  by  the  creation  of  these  facilities,  would  have 
been,  or  will  be,  taxed  that  other  sections  might  use 
them  toll  free.  The  Federal  policy  of  harbor  and  river 
improvement  is  also  a  policy  of  subsidizing  commerce, 
and  is,  therefore,  popular  with  and  favored  by  the  in- 
terests subsidized.  Like  the  protective  tariff  policy, 
the  policy  of  subsidizing  water  transportation  is  partly 
the  result  of  bargaining  between  representatives  of  differ- 
ent districts,  each  trying  to  get  something  at  the  general 
expense.  The  British  system  of  a  Public  Harbor  Trust 
avoids  private  monopoly  of  facilities,  but  makes  the 
traffic  using  the  facilities  provided,  pay  for  them. 

Land  grants  to  railways,  like  other  aids  to  water  trans- 
portation, are  indirect  subsidies  given  to  commerce,  and, 
as  such,  are  open  to  objections.  The  general  rule  which 
it  is  safest  for  government  to  follow,  is  that  those  who 
chiefly  benefit  by  facilities  provided  for  commerce  should 
chiefly  pay  for  them,  rather  than  that  these  facilities 
should  be  paid  for  by  the  people  in  general,  without 
regard  to  proportionate  benefits  received. 


INDEX 


Acceptance  bills,  form  of  documentary 
commercial  drafts  called,  I.  69. 

Advertising  value  of  a  nation's  ship- 
ping, II.  150-160. 

Agriculture,  results  of  a  policy  of 
protection  to,  II.  72-73;  fallacious 
home  market  argument  for  pro- 
tection addressed  to  those  concerned 
in,  124-127;  the  argument  for 
protection  to,  in  the  older  countries, 
against  a  doubtful  future,  127-129. 

Arbitraging  in  exchange,  I.  96-97. 


B 


Bank  acceptances,  system  of,  used  in 
Europe,  I.  37~39,  69. 

Bank  credit,  nature  of,  I.  26  ff . ;  rela- 
tion of  money,  together  with,  to 
prices,  43-45 ;  fluctuations  of,  due 
to  periods  of  hope  and  confidence 
and  of  doubt  and  fear,  46;  changes 
in,  resulting  from  panics,  46-47; 
means  provided  for  avoiding  violent 
fluctuations  of,  47-49. 

Bank  deposits,  I.  28. 

Bank  drafts,  use  of,  I.  52 ;  both  drawers 
and  drawees  of,  are  banks,  54; 
settlement  of  obligations  by,  when 
debtors  remit  to  creditors,  61  ff. ; 
different  types  of,  67-70.  See  Long 
drafts  and  Sight  drafts. 

Banking,  commercial,  I.  28-30;  anal- 
ysis of  the  relations  to  each  other 
of  persons  concerned  in,  30-33; 
advantages  possessed  by,  for  busi- 
ness men,  both  as  lenders  and  bor- 
rowers, 33-40. 

Bank  notes,  are  credit  obligations  of 
banks  to  holders  of,  I.  41 ;  pro- 
tection of  holders  against  loss, 
41-43;  provisions  of  Federal  Re- 
serve Act  relative  to,  42-43- 


Bank  of  England,  emergency  reserve 
of,  I.  47- 

Bank  reserves,  I.  42,  44;  method  of 
maintaining  proper  relation  between 
deposits  and,  44-45. 

Banks,  function  of,  to  act  as  inter- 
mediaries between  borrowers  and 
lenders,  I.  30-33 ;  Federal  reserve, 
42-43- 

Barter,  primitive  trade  called,  I.  i. 

Bastable,  The  Theory  of  International 
Trade,  cited,  I.  92,  113,  141,  143,  II. 
25,  30,  50,  54,  74,  81,  107,  132. 

Beet  sugar  industry,  bounty  granted, 
in  Europe,  II.  144 ;  effects  of  boun- 
ties on  bounty-paying  countries  and 
on  sugar-consuming  countries,  151- 
152. 

Bills  of  exchange,  I.  26,  27,  51-53; 
advantages  of,  over  checks  for  long- 
distance transactions,  52-53 ;  nature 
of,  53-54 ;  relations  of  bank  to  other 
parties  concerned  in,  53-54;  il- 
lustration of  use  of,  to  settle  obli- 
gations, assuming  no  banks,  54-56; 
settlement  of  obligations  by,  through 
intermediation  of  banks,  assuming 
creditors  to  draw  drafts  on  debtors, 
56-61 ;  settlement  by  bank  drafts, 
when  debtors  remit  to  creditors, 
61-65;  variety  of  types  of,  67-70; 
sight  drafts  and  long  bills,  67; 
"clean"  bills  and  documentary, 
67-69;  discount  of,  69-70;  sale  of 
demand  drafts  against  remittances' 
of  long  bills,  71-73;  method  of 
drawing  of,  by  letters  of  credit, 
94-96;  speculation  in,  96-100; 
relation  between  price  of  long  drafts 
and  rate  of  interest  or  discount, 
126-127;  holding  of  long  drafts  on 
foreign  countries  by  American  banks, 
as  investments,  127-130;  influence 
on  price  of  long  drafts  of  interest 
rate  in  drawing  country  and  interest 


189 


INDEX 


rate  in  country  drawn  upon,  131- 
133;  effect  of  bank  discount  rate 
on  price  of  demand  drafts  and  the 
flow  of  specie,  133-136;  fluctua- 
tions in  price  of,  in  case  of  prohi- 
bition of  specie  shipment,  147-150. 

Bimetallism,  operation  of  theory  of, 
I.  16-18. 

Borrowers,  relation  between  lenders 
and,  in  commercial  banking,  I. 
30-33;  benefits  to,  from  banking 
system,  35-37- 

Bounties,  nature  and  effects  of,  II. 
144  ff. ;  as  compared  and  contrasted 
with  protection,  144-145 ;  effect  of, 
on  level  of  money  prices  in  bounty- 
paying  countries,  146-148;  conse- 
quences of,  to  general  welfare  of 
bounty-paying  country  and  of 
countries  with  which  it  trades, 
148-152;  effects  on  wages  and 
rent,  152-153 ;  less  objectionable 
than  protection  for  encouraging 
infant  industries,  153;  comparison 
of  shipping  subsidies  and,  157-158. 


Canada,  protection  of  holders  of 
bank  notes,  under  banking  system 
of,  I.  41. 

Canals,  the  free  use  of  government- 
built,  II.  16.3,  165-172 ;  comparison 
of  railroads  and,  as  to  economy, 
170-171 ;  burden  of  building,  borne 
by  taxpayers,  171-172. 

Carver,  views  of,  on  protection,  II. 
1 08  n. 

Checks  on  banks,  common  form  of 
credit,  I.  26,  27 ;  similarity  of  bills 
of  exchange  to,  52;  advantages  of 
bills  of  exchange  over,  in  long- 
distance transactions,  52-53. 

Clare,  The  A. B.C.  of  the  Foreign  Ex- 
changes, cited,  I.  63,  83,  93,  97, 140. 

"Clean"  bills,  defined,  I.  67. 

Clearing  houses,  I.  29,  30. 

Coal,  protective  tax  on,  at  expense  of 
wage-earning  public,  II.  99. 

Coasting  trade,  United  States  laws 
concerning,  II.  155;  plan  of  grant- 
ing free  use  of  Panama  Canal  to 
American,  165-169. 


Commercial  drafts,  use  of,  I.  52  ff.; 
character  of  drawers  and  drawees  of, 
53-54;  method  of  using,  for  settle- 
ment of  obligations,  54  ff. 

Competition,  effect  of,  on  prices,  I. 
6-8;  monopolies  secured  against 
foreign,  by  protective  tariff,  II.  113. 

Constitutional  justification  of  a  pro- 
tective tariff,  II.  112-113. 

Cotton-raising  states,  disadvantages 
of  protective  tariff  to,  II.  112. 

Credit,  substitution  of,  for  money,  I. 
26-27. 

Crops,  relation  between  rate  of  ex- 
change and,  I.  82-83. 

Currencies,  effect  of  difference  in,  on 
exchange  between  two  countries, 
I.  138-142. 

Currency,  use  of  term,  I.  26. 

Currency  loans,  I.  85,  86. 

Customer's  check,  use  of,  for  money, 
1.27. 

D 

Day,  A  History  of  Commerce,  cited,  II.  70. 

Demand  drafts,  sale  of,  against  remit- 
tances of  long  bills,  I.  71-73.  See 
Sight  drafts. 

Diminishing  utility,  law  of,  II.  28. 

Discount,  effect  of,  on  price  of  long 
drafts,  I.  126-127;  effect  of  bank 
discount  rate  on  price  of  demand 
drafts  and  the  flow  of  specie,  133- 
136;  effect  of  panics  on  rate  of, 
137-138. 

Discounting  of  documentary  payment 
bills,  I.  69-70. 

Discount  market,  absence  of  a,  in 
United  States,  I.  72-73. 

Diversification-of -industries  argument 
for  protection,  II.  134-135. 

Documentary  commercial  drafts,  I. 
67,  68-69. 

Domestic  exchange,  cost  of  money 
shipment  in,  I.  115-116. 

E 

Edgeworth,  "Report  on  Monetary 
Standard,"  cited,  I.  3 ;  "The  Theory 
of  International  Values,"  cited,  II. 
21 ;  discussion  of  view  of.  regarding 
effect  of  import  duty,  48  n,  107-108  n. 


INDEX 


191 


Employment,  the  argument  that  pro- 
tection makes,  II.  122-124. 

England,  exchange  transactions  be- 
tween America  and,  I.  62-65 »  dis- 
counting in,  of  bills  drawn  by  Amer- 
icans on  their  English  debtors,  71-72 ; 
wages  and  prices  in  Germany 
and,  compared,  II.  96;  error  made 
in  comparing  conditions  as  to  wages 
in  United  States  and,  120-122; 
weakness  of  national  self-sufficiency 
argument  for  protection  shown  by 
case  of,  136-137;  gain  to,  from 
export  bounties  paid  on  beet  sugar 
by  other  countries,  151-152;  early 
navigation  acts  of,  155.  See  also 
Great  Britain. 

Equation  of  exchange  of  money,  I. 
3-4,  24;  statement  of,  including 
bank  credit,  43. 

Erie  Canal,  the  free  use  of,  an  injus- 
tice to  taxpayers  of  New  York  State, 
II.  160-170. 

Escher,  Elements  of  Foreign  Exchange, 
cited,  I.  65,  67,  69,  70,  71,  85,  90, 
93,  94,  96,  97,  99,  109,  in. 

Ethics  of  the  question  of  protection 
or  free  trade,  II.  139. 

European  war,  and  the  exchange 
market,  I.  107 ;  effect  of,  on  flow  of 
specie  abroad,  136  n. 

Exchange,  foreign  and  domestic,  I. 
52-53;  par  of,  77-78,  139;  place 
speculation  or  arbitraging  in,  96-97  ; 
time  speculation  in,  97-100;  be- 
tween two  countries  when  one  has 
a  gold  and  the  other  a  silver  stand- 
ard, 138-142.  See  Bills  of  exchange 
and  Rate  of  exchange. 

Exchangeability  of  money,  I.  2. 

Exchange  banks  and  brokers,  I.  53,  56 ; 
how  profits  are  made  by,  65-67. 

Exchange  market,  the,  I.  65;  effect 
on,  of  disturbed  political  or  indus- 
trial conditions,  83-84;  demoraliza- 
tion of,  by  the  European  war, 
107. 

Exportation  of  specie  and  the  rate  of 
exchange,  I.  107-111. 

Export  duties,  effect  of  high,  on  rate 
of  exchange,  I.  151 ;  consequences 
of,  when  levied  for  revenue,  II. 
52-55;  effect  of  protective,  on  a 


country's  trade,  57-60;  effect  of, 
on  flow  of  specie  and  on  money 
prices  in  tax-levying  country,  69- 
70. 

Export  trade,  influence  of  rate  of 
exchange  on,  I.  118-119;  injury 
resulting  to  a  country's,  from  policy 
of  protection,  II.  58-59. 


F 


Farmers,  a  tariff  for  benefiting  wage- 
earners  at  expense  of,  II.  loo-no; 
home  market  argument  for  pro- 
tection addressed  to,  124-127. 

Federal  Reserve  Act,  provisions  of, 
relative  to  national  bank  notes,  I. 
42-43;  function  of  Federal  reserve 
banks  established  by,  47 ;  provisions 
of,  for  suspending  reserve  require- 
ments, 48;  rediscounting  permitted 
and  encouraged  by,  73. 

Federal  reserve  banks,  reserves  kept 
by,  I.  47- 

Fiat  money,  I.  8,  13. 

Finance  bills,  I.  90-93. 

Financial  disturbances,  influence  of, 
on  rate  of  exchange,  I.  113-114. 

Firsts  and  seconds,  explanation  of 
terms,  applied  to  drafts,  I.  128. 

Fisher,  Irving,  Elementary  Principles 
of  Economics,  cited,  I.  5,  17,  II.  5  ; 
The  Purchasing  Power  of  Money, 
cited,  I.  14,  19,  22,  28,  43,  45, 137, 
II.  67. 

Fisk,  International  Commercial  Policies, 
cited,  II.  151. 

Foreign  exchange,  nature  and  method 
of,  I.  51  ff. 

Free  trade,  meaning  of,  II.  39-40; 
advantages  to  countries  adhering  to 
principles  of,  80-83;  wages  and 
prices  under  protection  and,  com- 
pared, 96;  condition  of,  between 
States  of  United  States  an  argument 
for  successful  operation  of,  between 
nations,  137-138.  See  Revenue 
tariff. 

Fuller,  Herbert  Brace,  "American 
Waterways  and  the  Pork  Barrel," 
cited,  II.  176,  179. 

Futures,  speculation  in,  in  foreign 
exchange,  I.  98-99. 


192 


INDEX 


Geographical  specialization  in  pro- 
duction of  goods,  II.  8-9;  inter- 
ference with,  under  conditions 
created  by  a  protective  tariff,  62- 

63. 
George,    Henry,    Protection   and   Free 

Trade,  cited,  II.  120. 
Germany,   comparison  of    wages  and 

prices    in    England    and,    II.    96; 

argument    used    for    protection    to 

agriculture  in,  127-129;   beet  sugar 

bounty    in,     151-152;     conclusions 

concerning    waterway    system    of, 

171. 
Gold,   value  of  money  as  related  to 

value  of,  I.  21-22.    See  Specie. 
Goschen,    The   Theory  of  the  Foreign 

Exchanges,  cited,  I.  89,  92,  113,  131, 

134,  136,  140,  142,  143. 
Great  Britain,  advantages  secured  by 

policy  of  free  trade  in,  II.  81-83; 

system  of  harbor  improvement  and 

lighthouse  maintenance  followed  in, 

174-176. 

H 

Hadley,  Economics,  cited,  I.  3,  7,  n. 

122  n. 
Haney,    A    Congressional    History    of 

Railways  in  the  United  States,  cited, 

n.  182. 

Harbors,  uneconomic  improvement  of, 
at  public  expense,  II.  172  ff. ;  British 
system  of  improvement  and  main- 
tenance of,  174-176. 

Harbor  trusts  in  Great  Britain,  II. 
I74-I7S. 

Hart,  A.  B.,  Essentials  in  American 
History,  cited,  II.  138. 

Home  market  argument  for  protection, 
II.  124-127. 

I 

Immigration,  danger  to  wages  in 
United  States  from,  rather  than 
from  lack  of  protective  tariff,  II. 
121-122. 

Importation  of  specie  and  the  rate  of 
exchange,  I.  111-113. 

Importations,  influence  of  rate  of 
exchange  on  amount  of,  I.  118-119. 


Import  duties,  effect  of  high,  on  rate  of 
exchange,  I.  150-151;  two  classes 
of,  II.  39;  conditions  where,  when 
levied  for  revenue,  the  burden  is 
borne  by  the  levying  country,  41-43 ; 
shifting  of  burden  by  the  levying 
country  to  another  or  other  coun- 
tries, 44-51 ;  effect  of  protective, 
on  a  country's  trade,  57  ff. ;  un- 
profitable industries  set  up  at  the 
general  expense  by  protective,  60- 
66.  See  Protective  tariff. 

Incomes,  loss  in  the  way  of,  resulting 
from  system  of  protection,  II.  68-69. 

Individualism,  philosophy  of,  applied 
to  use  of  finance  bills,  I.  92-93. 

Inefficiency,  encouragement  of,  in 
some  degree,  by  protective  tariff, 
II.So. 

Infant  industry  argument  for  pro- 
tection, II.  129-134;  as  applied 
to  bounties,  153. 

Insurance  rates  on  gold  shipments, 
I.  107. 

Intercommunity  trade,  II.  11-17; 
limits  to  fluctuations  of,  19  ff. 

Interest,  loss  of,  during  transportation 
of  gold,  I.  107-109;  relation  be- 
tween rate  of,  and  price  of  long 
drafts,  126-127,  131-133;  statement 
of  theory  of,  II.  86;  effect  of  pro- 
tection on  rate  of,  86-89. 

International  trade,  distinction  be- 
tween intranational  and,  one  of 
degree  only,  II.  16-17. 

Investment,  character  of,  as  a  part  of 
trade,  II.  29  n. 

Investments,  long  run  effect  of  in- 
ternational, upon  rate  of  exchange 
and  flow  of  money,  I.  120-122; 
long  drafts  on  foreign  countries 
held  by  American  banks  as,  127-130. 


Jacobs,  L.  M.,  "Bank  Acceptances" 

by,  cited,  I.  37  n.,  73. 
Johnson,    Ocean    and    Inland    Water 

Transportation,  cited,  II.  173,  175; 

American    Railway    Transportation, 

cited,  182. 
Joint    account,    investment    by    two 

banks  for,  I.  93-94. 


INDEX 


193 


Kemmerer,  Money  and  Credit  In- 
struments in  their  Relation  to  General 
Prices,  cited,  I.  43. 


Land  grants  to  railroads,  II.  182-186. 

Land  rent,  laws  of  wages  and,  II. 
80-92 ;  effect  of  protection  on 
wages  and,  under  varying  condi- 
tions, 93-110;  effect  of  bounties 
on,  152-153. 

Large  scale  production,  protective 
tariff  and,  II.  71-72. 

Laws  of  money,  I.  i  ff. 

Lenders,  viewed  as  persons  who 
provide  waiting,  I.  30-33;  ad- 
vantages to,  of  system  of  com- 
mercial banking,  34-35. 

Letters  of  credit,  analysis  of  relations 
involved  in,  I.  94—96. 

Levi,  The  History  of  British  Com- 
merce, cited,  II.  70. 

Lighthouses,  maintenance  of,  by  a 
central  government,  II.  172,  175- 
176. 

Limping  standard,  conditions  for 
successful  operation  of  the,  I. 
10-21. 

Lindsay,  History  of  Merchant  Ship- 
ping, cited,  II.  155. 

Loans,  short  time,  made  through 
intermediation  of  exchange  market, 
I.  85  ff. ;  sterling  and  currency, 
85-86. 

London,  the  world's  financial  centre, 
I.  63-64;  effect  on  disposal  of 
long  drafts  at  lower  discount  rate 
in,  than  in  New  York,  133. 

Long  drafts  or  bills,  I.  67;  sale  of 
demand  drafts  by  banks,  against 
remittances  of,  71-73 ;  effect  on 
price  of,  of  rate  of  interest  or  dis- 
count, 126-127;  method  of  pro- 
cedure when  held  as  investments 
by  American  banks,  127-130;  in- 
fluence on  price  of,  of  interest 
rate  in  drawing  country  and  of 
interest  rate  in  country  drawn 
upon,  131-133. 


Loria,  "Effects  of  Import  Duties  in 
New  and  Old  Countries,"  cited, 
II.  I06. 


M 


Make-work  argument  for  protection, 
fallacy  of  the,  II.  122-124. 

Manufactures,  consequences  of  policy 
of  protection  to,  II.  73. 

Margraff,  International  Exchange, 
cited,  I.  70,  96  n.,  128,  130. 

Marks,  Lawrence  M.,  statistics  of 
rate  of  exchange  compiled  by,  I. 
83  n. 

Marshall,  memorandum  on  effect 
in  international  trade  of  different 
currencies,  I.  141  n. 

Mason,  "The  American  Silk  Industry 
and  the  Tariff,"  cited,  II.  130. 

Meeker,  R.,  History  of  Shipping 
Subsidies,  cited  and  quoted,  II. 
!4S»  159,  161,  162. 

Military  argument  for  protective 
tariff,  to  insure  national  self- 
sufficiency,  II.  135-137 ;  for  ship- 
ping subsidies,  as  a  means  of  in- 
creasing a  nation's  naval  strength, 
161-162;  for  building  Panama 
Canal,  168. 

Mill,  J.  S.,  Principles  of  Political 
Economy,  cited,  I.  5,  II.  21,  24,  25, 
26,  45,  46,  52,  74;  System  of  Logic, 
cited,  II.  120. 

Mississippi  River,  unwise  expenditure 
of  money  in  improvement  of,  II. 
176-177- 

Monetary  standards,  effect  of  differ- 
ent, on  exchange  between  two 
countries,  I.  138-142 ;  rate  of 
interchange  of  goods  between  coun- 
tries not  affected  by  difference 
in,  II.  24-25. 

Money,  laws  of,  I.  i  ff. ;  position  of, 
as  a  medium  of  exchange,  2-3; 
relation  between  prices  and,  3; 
causal  explanation  of  value  or 
"purchasing  power"  of,  12-16; 
theory  of  bimetallism,  1 6-i  8;  value 
of  subsidiary,  10-21 ;  relation  of 
value  of,  to  value  of  a  standard 
money  metal,  21-22;  relation  be- 
tween level  of  prices  and  value  of, 


PART  n  —  o 


194 


INDEX 


in  one  country  or  locality  and  level 
of  prices  and  value  of,  in  another, 
22-24;  substitution  of  credit  for, 
26—27 ;  reasons  why  bank  credit 
is  able  to  displace,  as  a  medium  of 
exchange,  33  ff. ;  relation  of,  to- 
gether with  bank  credit,  to  prices, 
43-45;  substitutes  for,  in  inter- 
national and  long-distance  trade, 
52 ;  cost  of  shipment  of,  in  domestic 
exchange,  115-116;  fallacy  of  the 
argument  for  protection,  that  it 
keeps  money  in  the  protected 
country,  II.  116-118;  argument 
for  shipping  subsidies  based  on, 
158. 

Monopolies,  differing  prices  of  goods 
of,  at  home  and  abroad,  II.  4  n. ; 
protective  system  as  an  encourage- 
ment to,  113. 

Moulton,  Waterways  versus  Railways, 
cited,  II.  171. 

N 

National  banks,  guaranteeing  of  notes 
issued  by,  by  Federal  government, 

I.  41-42  ;  foreign  exchange  business 
of,  65-66. 

Naval  reasons  for  shipping  subsidies, 

II.  161-162. 

Navigation      laws,      II.       155-156; 

analogous     to     protective     tariffs, 

156-157- 
Newcomb,     Principles     of     Political 

Economy,  cited,  I.  3. 


Panama  Canal,  question  of  indirectly 
subsidizing  American  ships  by 
allowing  them  free  use  of,  II. 
163;  lack  of  economic  justification 
for  plan  of  allowing  American 
coasting  trade  free  use  of,  165-169. 

Panics,  effect  of,  on  bank  credit, 
I.  46-47;  lowering  of  rate  of  ex- 
change due  to,  113-114;  effect  of, 
in  one  country  on  discount  rate 
and  flow  of  specie  in  other  coun- 
tries, 137-138. 

Paper  money,  exchange  between 
countries  under  existence  of,  as  an 
inconvertible  standard,  I.  142-147. 


Parasitic  industries,  establishment  of 
by  protective  tariff,  II.  60-66. 

Par  of  exchange,  I.  77-78;    establis 
ment  of  a  new,  between  countries 
with  different  monetary  standards, 
139. 

Patten,  Economic  Basis  of  Protection, 
cited,  II.  106. 

"Pauper  labor"  argument  used  by 
protectionists,  II.  110-120. 

Place  speculation  in  exchange,  I. 
96-^97. 

Politics,  part  taken  by,  in  the  pro- 
tection of  infant  industries,  II. 
132-133  J  operation  of,  in  American 
waterway  development,  178-181. 

Population,  density  of,  and  rate  of 
wages,  II.  1 20-i  21. 

"Pork  barrel"  system  of  waterway 
development,  II.  178-181. 

Prices,  quantitative  statement  of 
relation  between  money  and,  I. 
3-4;  causal  explanation  of,  of 
given  kinds  of  goods,  5-8;  causal 
explanation  of  general  level  of, 
8—i  2 ;  relation  between  level  of, 
and  value  of  money  in  one  country 
or  locality  and  level  of,  and  value 
of  money  in  another,  22-24;  re- 
lation of  money,  together  with  bank 
credit,  to,  43-45 ;  influence  of,  in 
the  long  run,  on  the  exchange 
market,  116-120;  affected  by  bank 
discount  rate,  135-136;  effect  of 
a  panic  in  one  country  on  level  of, 
in  other  countries,  137-138;  effect 
on,  of  different  currencies  in  two 
different  countries,  138-142 ;  ten- 
dency of,  through  influence  of 
trade,  toward  equality  in  different 
countries,  II.  3-7 ;  tendency  of, 
to  be  lower  in  the  country  where 
goods  can  be  produced  with  greatest 
relative  advantage,  7-11;  high 
rate  of  wages  does  not  imply  high, 
9;  effects  of  protective  tariff  on, 
67—70,  74—78;  effect  of  bounties 
on  level  of,  in  bounty-paying 
countries,  146-148;  effect  of  arti- 
ficial navigation  laws  on,  156. 

Promissory  notes,  use  of,  for  money, 
I.  26-27. 

Protection.    See  Protective  tariff. 


INDEX 


Protective  tariff,  effect  of,  on  rate 
of  exchange,  I.  150-151 ;  distinction 
between  revenue  tariff  and,  II. 
30-41 ;  effect  of,  on  a  country's 
export  trade,  57-60;  how  unprofit- 
able industries  are  set  up  at  the 
general  expense  by,  60-66;  view 
of,  as  "mutual  tribute,"  64;  effect 
of,  on  money  prices  of  protected 
and  of  unprotected  goods,  67-70; 
improbability  of  increase  of  national 
wealth  by,  71  n.;  operation  of, 
as  to  industries  in  which  large  scale 
production  is  advantageous,  71— 
72 ;  applied  to  industries  of  in- 
creasing cost,  72-74;  effect  on 
cost  of  unprotected  goods  got 
from  other  countries,  74-78; 
chimerical  proposition  as  to  estab- 
lishing a  tariff  "equal  to  the  differ- 
ence in  cost  of  production  at  home 
and  abroad,  together  with  a  reason- 
able profit,"  70-80;  not  necessarily 
conducive  to  efficiency  in  methods 
of  production,  80;  relative  advan- 
tages in  world's  commerce  of 
countries  having  high  and  countries 
having  low  or  no  tariffs,  80-83 ; 
effect  on  rate  of  interest  and  there- 
fore on  wages,  86-89;  effect  of, 
on  wages  and  rent  under  varying 
conditions,  97-110;  may  benefit 
one  section  of  a  country  at  the 
expense  of  other  sections,  in- 
113;  as  an  encouragement  to 
monopoly,  113;  the  argument  for, 
that  it  keeps  money  in  the  pro- 
tected country,  116-118;  the  wages 
argument  for,  118-122;  the  make- 
work  argument,  122-124;  the  home 
market  argument,  124-127;  the 
infant  industry  argument,  129- 
134;  diversification  of  industries 
argument,  134-135;  argument  con- 
cerning national  self-sufficiency,  135- 
137 ;  successful  working  of  free 
trade  between  States  of  United 
States  an  argument  against,  137- 
138;  ethical  considerations  bearing 
on  question  of,  139;  bounties  as 
compared  and  contrasted  with, 
144-145;  analogy  between  naviga- 
tion laws  and,  156-157;  points 


of  similarity  of  shipping  subsidies 
and,  157-158. 

Purchasing  power  of  money,  a  phrase 
used  to  express  the  price  of  money, 
I.  12-13;  explanation  of,  13-16. 


Quantity  theory  of  money,  I.  3-4. 


Railroads,  comparison  of  canals  and, 
as  to  economy,  II.  170—172;  com- 
parison of  transportation  costs  on 
rivers  and,  177-178;  subsidies  to 
building  of,  181-186;  error  made 
in  giving  municipal  or  local  aid  to, 
1 86. 

Railroad  wages,  study  of,  II.  96  n. 

Rate  of  exchange,  I.  77  ff.;  causes 
of  fluctuation  in,  78;  effect  on,  of 
disturbed  political  or  industrial 
conditions,  83-84;  short  time  loans 
and,  85-90;  upper  limit  to  fluctua- 
tion of,  determined  by  cost  of 
exporting  specie,  103-107;  lower 
limit  to  fluctuation,  determined 
by  cost  of  importing  specie,  m- 
113 ;  influence  of  panics  or  financial 
disturbances  on,  113-114;  long 
run  effects  on,  of  a  balance  of  pay- 
ments from  one  country  to  another, 
116  ff. ;  long  run  effect  of  inter- 
national investments  on,  120-122; 
long  run  effect  of  payments  for 
various  purposes  on,  122-124; 
when  one  of  two  countries  has  a 
gold  and  the  other  a  silver  standard, 
138-142  ;  when  one  of  two  countries 
has  a  gold  and  the  other  an  incon- 
vertible paper  standard,  142-144; 
conditions  as  to,  in  case  of  pro- 
hibition of  specie  shipment,  147- 
150;  effect  on,  of  high  import  and 
export  duties,  150-151. 

Rate  of  interchange  of  goods  between 
communities,  II.  19  ff-;  deter- 
mination of,  by  conditions  of  supply 
and  demand,  22-25 ;  effect  on, 
when  one  country  offers  a  variety 
of  goods,  26-27;  effect  when  one 
country  receives  periodic  payments 


xg6 


INDEX 


of  obligations  from  another,  27- 
29;  effect  of  production  in  any 
country  under  conditions  of  differ- 
ent cost,  29-32;  under  conditions 
involving  more  than  two  coun- 
tries, 32-35;  tariffs  and,  39  ff. 

Rate  of  interest,  effect  of  protection 
on,  II.  86-89. 

Rediscounting  bills  of  exchange,  I. 
71-72;  not  practised  in  United 
States,  72-73- 

Rent.    See  Land  rent. 

Reserves  in  banks,  I.  42,  44. 

Revenue  tariff,  II.  39  ff.;  conditions 
under  which  it  is  borne  by  the 
levying  country,  41-43 ;  shifting 
of  burden  by  the  levying  country 
to  another  or  other  countries,  44— 
51 ;  consequences  of  a,  on  exports, 
52-55- 

Rivers,  uneconomic  improvement  of, 
by  United  States,  II.  176-181. 

S 

Sanborn,  Congressional  Grants  of  Land 
in  Aid  of  Railways,  cited,  II.  182. 

Seasonal  variations  of  trade,  desir- 
ability of  elasticity  in  bank  currency 
to  meet,  I.  48,  50. 

Self-sufficiency,  argument  for  protec- 
tion in  order  to  get  and  maintain 
national,  II.  135—137. 

Selling  short  in  foreign  exchange,  I. 
99-100. 

Shipping,  navigation  laws  designed 
to  encourage,  II.  155-157;  ad- 
vertising value  of,  159-160. 

Shipping  subsidies,  II.  144;  shown 
to  be  without  economic  justifica- 
tion, 157-162;  naval  reasons  for, 
161-162;  indirect,  favoring  native 
ships  as  compared  with  foreign 
ships,  163-165. 

Short  time  loans  made  through  the 
exchange  market,  relations  involved 
in  and  results  of,  I.  85-90. 

Sidgwick,  views  of,  on  protection, 
II.  107  n. 

Sight  drafts,  I.  67 ;  rate  on,  constitutes 
the  pure  rate  of  exchange,  126; 
relation  between  bank  discount 
rate  and  price  of,  133-136. 


Silk  industry  in  United  States,  an 
example  of  infant  industry  argu- 
ment, II.  130. 

Smith,  The  Organization  of  Ocean 
Commerce,  cited,  II.  174. 

Southern  states,  effect  of  protective 
system  on  the,  II.  112. 

Specie,  rate  of  exchange  and  the 
flow  of,  I.  103  ff. ;  upper  limit  to 
fluctuation  of  rate  of  exchange 
determined  by  cost  of  exporting, 
103-107 ;  details  connected  with 
exportation  of,  107-111;  lower 
limit  to  fluctuation  of  rate  of  ex- 
change determined  by  cost  of  im- 
porting, 111-113;  long  run  effects 
on  flow  of,  of  a  balance  of  payments 
from  one  country  to  another, 
116  ff. ;  long  run  effects  on  flow 
of,  of  international  investments, 
120-122;  effect  of  bank  discount 
rate  on  price  of  demand  drafts  and 
the  flow  of,  133-136;  flow  of, 
abroad  prior  to  outbreak  of 
European  war,  136  n. ;  effect  of 
panics  on  flow  of,  137-138;  effect 
on  flow  of,  of  different  currencies 
in  two  countries,  138  ff . ;  exchange 
between  two  countries,  assuming 
prohibition  of  shipment  of,  147-150. 

Speculation  in  foreign  exchange,  I. 
96-100. 

Sterling  loans,  I.  85-86. 

Stock  exchange,  New  York,  closing 
of,  to  impede  flow  abroad  of  specie, 
I.  136  n. 

Subsidiary  money,  conditions  deter- 
mining successful  employment  of, 
I.  19-21. 

Subsidies,  to  shipping,  II.  144,  157- 
165;  to  railroad  building,  181-186. 

Sumner,  William  Graham,  Protec- 
tionism, cited,  II.  61,  82,  126,  136, 
152  ;  quoted,  64,  65,  134. 

Supply  and  demand,  relation  between 
price  of  a  given  kind  of  goods  and, 
I.  5-8 ;  application  of  principles  of, 
to  the  general  level  of  prices,  8- 
12;  applied  to  money  and  prices, 
13-16 ;  effects  of  laws  of,  on  various 
monetary  systems,  16;  price  of 
bills  of  exchange  or  drafts  deter- 
mined by,  77;  forces  affecting,  of 


INDEX 


197 


bills  of  exchange,  78-83 ;  conditions 
of,  determining  rate  of  interchange 
of  goods  between  countries,  II. 
22-25. 


Tariffs,  effect  of,  on  location  of  in- 
dustries, II.  1 1 ;  revenue  and  pro- 
tective, distinguished,  30-41.  See 
Protective  tariff  and  Revenue 
tariff. 

Time  drafts,  I.  127. 

Time  speculation  in  exchange,  I. 
97-100. 

Trade,  primitive,  I.  i ;  money  as  a 
part  of  the  mechanism  of,  1-2 ; 
conditions  governing  intercommu- 
nity, ii— 16;  international  compared 
with  intranational,  16-17;  condi- 
tions regulating  rate  of,  between 
communities,  19  ff . ;  supply  and 
demand  as  the  determining  factor 
in,  22-25 ;  effect  on  rate  of,  when 
one  country  offers  a  variety  of 
goods  and  when  it  receives  periodic 
payments  of  obligations  from  the 
other,  26-29;  influence  of  produc- 
tion in  any  country  under  conditions 
of  different  cost,  20-32;  effect  of 
entrance  of  an  additional  country 
into,  32-35;  cost  of  transportation 
as  related  to,  36;  revenue  tariffs 
and,  30-56;  effects  of  a  protective 
tariff,  57  ff.  See  also  Rate  of  inter- 
change of  goods. 

"Trade  follows  the  flag"  argument 
for  shipping  subsidies,  II.  159. 

Transportation,  cost  of,  of  money, 
in  domestic  exchange,  I.  115-116; 
cost  of,  as  related  to  trade,  II.  36; 
navigation  laws  and  shipping  sub- 
sidies for  encouragement  of,  by 
water,  155  ff. ;  comparison  of 
railroads  and  canals  for  purposes  of, 
170-172;  comparison  of  cost  of, 
on  railroads  and  on  rivers,  177-178. 

Taussig,     Principles     of    Economics, 


cited,  I.  115,  121,  II.  7,  23,  27,  74, 
in,  127. 

V 

Variety  of  goods,  advantages  to 
country  offering,  for  export,  II. 
26-27. 

Velocity  of  circulation,  relation  be- 
tween supply  of  money  and,  I. 
13-14- 

W 

Wages,  high  rate  of,  does  not  imply 
that  goods  cannot  be  produced  and 
exported  at  low  money  cost,  II.  9; 
reduction  of,  resulting  from  rise 
in  rate  of  interest  due  to  protective 
policy,  88—89  >  laws  of  wages  and 
land  rent,  80-92;  effect  of  protec- 
tion on,  when  protected  and  un- 
protected goods  are  produced  under 
conditions  of  substantially  constant 
cost,  93-96;  effect  of  bounties  on, 
152-153- 

Wagner,  Adolph,  Agrar-  und  Indus- 
triestaat,  cited,  II.  127. 

Waiting,  element  of,  provided  by 
depositors  or  lenders,  in  commer- 
cial banking,  I.  30-33. 

Walker,  Political  Economy,  cited,  1. 13. 

Wampum,  medium  of  exchange  among 
Indians,  I.  i. 

War,  the  European,  and  the  exchange 
market,  I.  107;  effect  on  flow  of 
specie  to  Europe,  136  n. 

Warburg,  Paul  M.,  "The  Discount 
System  in  Europe,"  cited,  I.  37  n.; 
quoted,  72  n. 

Weighted  average,  defined,  II.  5. 

Wheat-producing  areas,  disadvantages 
of  protective  tariff  to,  II.  112. 

White,  Money  and  Banking,  cited,  I. 
44- 

Wool  industry,  protective  tariff  and, 
in  United  States,  II.  61 ;  an  illus- 
tration of  the  establishment  of  a 
parasitic  industry  at  the  general 
expense,  65,  99-100. 


14  DAY  USE 

RETURN  TO  DESK  FROM  WHICH  BORROWED 

LOAN  DEPT. 

This  book  is  due  on  the  last  date  stamped  below,  or 

on  the  date  to  which  renewed. 
Renewed  books  are  subject  to  immediate  recall. 


REC'D  i-   ' 

m    V64-3.PM 

OPU'SiQ 

REC'D  LD 

ccp  in  '65-''  M 

OUT     A*"*     «r»» 

SEP  18  1973 

• 

ffftVe  ^ 

•r 

-  •  g 

•  ^^ 

gECD  CIRC  DfcPt 

3UH 

LD  21A-40m-ll,'6; 
(E1602slO)476B 


j-i^»  ^ij.^i.— uu«t.-o,  o v 

(C8481slO)476B 


General  Library 

University  of  California 

Berkeley 

University  ot  Calitornia 
Berkeley 


YB    i °u 


£7 


UNIVERSITY  OF  CALIFORNIA  LIBRARY 


